By Kathy Lien, Managing Director of FX Strategy for BK Asset Management.
Don’t be fooled by the pullback in the U.S. dollar on Tuesday because the greenback could still strengthen before the end of the year. Nearly all of the major currencies rebounded because of local factors and not a shift in appetite for U.S. dollars or change in economic fundamentals. There’s been no data so far this week and stocks consolidated after Monday’s slide. The strength of USD/JPY, which is hovering around 114 and near 1.5 year highs is a confirmation of the dollar’s dominance. To answer the question of whether the dollar will get stronger, we have to revisit the 4 main reasons why its been rising this year.
4 Reasons USD Keeps Getting Stronger
- Good Data
- Rising Interest Rates
- Equity Market Pressure
- Trade Policy
Three out of four of these factors will still draw investors into the greenback. The Fed won’t give us a reason to question its policy direction until December while the strong dollar continues to eat away at corporate earnings. This will keep stocks under pressure and increase the risk of triple digit down days that cause investors to flock into U.S. dollars. Meanwhile we have very little reason to believe that the Trump Administration will change its protectionist trade policies. The only risk is U.S. data. This week we have consumer prices and retail sales scheduled for release. Both of these reports have a direct influence on Fed policy and will determine the market’s confidence in the Fed’s outlook. Economists are betting on an increase in CPI after the strong PPI but with oil prices falling 10% last month (and collapsing even further Tuesday), inflation may fall short of expectations. Retail sales could miss simply because wage growth slowed and the forecasts are high. Nonetheless, if data is good, the Fed will be vindicated and investors will have the confidence to take USD/JPY to 115.
The other factors that could stifle the dollar’s rally come from outside its borders. Tuesday's best-performing currency was sterling, which soared on the back of Brexit developments. Apparently the EU and UK have reached an agreement on how handle the Irish border. Prime Minister May is to meet with her ministers Tuesday night while the cabinet and EU will meet separately Wednesday, which means that a withdrawal agreement could be made public before the end of the week. Sterling traders are treading cautiously but if there is a Brexit deal, GBP/USD could squeeze to 1.31 and higher. The British pound also found support from UK data – although the unemployment rate increased in September, average weekly earnings grew 3%, up from 2.8% the previous month. A Brexit deal and rising wages will give the Bank of England the confidence to start talking about rate hikes again. Sterling remains in focus Wednesday as we will be watching for the latest on Brexit and UK CPI is scheduled for release.
There are reports that Italy has agreed on a 2.4% budget deficit for next year and maintain a 1.5% growth target. Last month, the European Union took the unprecedented step of rejecting Italy’s budget and warned that unsatisfactory changes could result in sanctions and fines. It is not clear whether these adjustments will satisfy the EU but based on the muted response for the euro, investors are not impressed. The latest Eurozone economic reports were also mixed. According to the ZEW survey, investors grew more pessimistic about the outlook for the Eurozone and German economy but more optimistic about current conditions in Germany. German third-quarter GDP numbers are scheduled for release on Wednesday and the risk is to the downside for this report with retail sales and trade weakening between July and September. Unlike other major currencies, EUR/USD remains in a deep downtrend until it rises back above 1.14.
The biggest story of the day was oil, which dropped more than 8% on an intraday basis, marking the 12th consecutive day of weakness. President Trump’s call for no production cuts from Saudi Arabia and OPEC accelerated the slide in crude and took oil to its lowest level since November 2017. So far the impact on the Canadian dollar has been limited but it will be very difficult for USD/CAD to fall if oil prices continue to slide. The Australian and New Zealand dollars also moved higher on reports that the U.S. and China will be holding talks at the upcoming G20 meeting. Unfortunately these talks are unlikely to yield anything significant as trade policy these days is determined on the president’s will and so far, there’s no reason to believe that he will be changing his stance and hold back the third round of tariffs on China. With that in mind, we still like the Australian and New Zealand dollars after recent data improvements. This week’s Australian labor-market numbers should be good as well.