By Kathy Lien, Managing Director of FX Strategy for BK Asset Management.
It may have been a tough week for the U.S. dollar, which was steady-to-lower against all of the major currencies but progress on tax reform helped fuel an end-of-week recovery. Taking a look at this week’s developments, the latest inflation and retail sales improvements helped the Federal Reserve upgrade its growth projections for this year and next. Unfortunately the dollar failed to benefit from these adjustments because the path of the economy and the central bank’s views could change materially by the time Jerome Powell chairs his first FOMC meeting in late March. Job growth could slow, beginning-of-the-year demand could retreat and corporations could keep wage growth low. With that in mind, the Fed raised its GDP forecasts, kept its inflation estimates unchanged and lowered its unemployment-rate projections to 3.9% for 2018 from 4.1%. The dot-plot forecast for 2018 and 2019 remained unchanged but rates are expected to reach 3.1% in 2020. Taken together, these adjustments make the Fed more – not less – hawkish but the dollar sold off rather than rally after the rate decision because 2 FOMC members dissented against the hike (they are not voting members next year) and Yellen warned that low inflation could be more ingrained than temporary. With that in mind, the prevailing thought is that with no further action expected at the January meeting, the next time we’ll get fresh guidance could be as late as mid March when Powell chairs his first monetary policy meeting. Next week’s U.S. housing reports, GDP revisions, personal income and spending numbers are not expected to alter these views. So that leaves the dollar at the whim of year-end flows and tax-reform headlines.
Despite stronger economic data and upgraded economic projections, the euro failed to extend higher after breaking out on Wednesday. The latest reports show service and manufacturing activity accelerating, leading to greater investor confidence. Next week’s German IFO report is expected to reinforce the improvement, giving euro a fresh catalyst to trade higher. Unfortunately on a technical basis, the currency looks weak and is poised for a retest of 1.1700. Fundamentally, the economy is strong – the ECB left interest rates unchanged and substantially upgraded its growth forecasts. ECB now sees the economy expanding by 2.4% this year, up from 2.2% and it raised its 2018 GDP forecast to 2.3% from 1.8%. The bank's inflation forecasts were left unchanged. Although the euro did not respond to these changes and Mario Draghi’s optimistic comments about the economy’s momentum due to his concerns about low inflation, we still think the euro’s losses will be limited. The central bank’s plans to keep rates steady until QE ends is not new and between now and then, if inflation rises, it could adjust its views. The Swiss National Bank also left interest rates unchanged and upgraded its growth and inflation forecasts. With that in mind, SNB still wants to see the franc lower and it warned of currency intervention as needed.
Like the Eurozone, the week was marked by better-than-expected U.K. data. Inflation is up, wage growth hit a 1-year high and retail sales blew out expectations in November. The Bank of England should have been overwhelmingly optimistic after these reports but instead of acknowledging the improvements, it said Q4 economic indicators are weaker than expected. In a twist of fate that contrasts with the euro and dollar’s reaction to central-bank optimism, sterling rallied despite the BoE’s cautious views but gave up those gains by the end of the week. Having just raised rates in November, U.K. policymakers are in no rush to tighten again – especially since it has yet to see the effects of November's hike. Prime Minister May was dealt a setback this past week when she lost a key Brexit vote. Lawmakers will now get final approval of the Brexit deal before withdrawal begins. May has long argued that this would delay the process and jeopardize chances of a smooth exit but sterling traders were simply happy that the EU voted to advance to the second phase of Brexit negotiations. Aside from revisions to the third-quarter GDP report, there are no market-moving releases on the U.K. calendar next week.
The Australian and New Zealand dollars saw strong gains over the past week. The moves in both currencies were fueled primarily by short covering but the selection of a new and experienced central-bank governor in New Zealand and unexpectedly strong Australian labor data provided a fundamental basis for the latest moves. The labor market is truly the greatest area of strength in Australia’s economy. Although business confidence declined, new jobs continued to add up. In the month of November, Australia generated 61K new jobs, 3 times more than expected. The unemployment rate held steady but the participation rate rose to 65.5%. Fully 80% of the jobs have been full-time, suggesting that broader GDP growth should remain sound for the foreseeable future. The solid pace of job growth stands as a stunning counterpoint to the recent soft data and should translate into better demand into the start of 2018. Looking ahead, the minutes from the most recent RBA meeting is the only piece of data worth watching next week from Australia and given the latest jobs report and pickup in Chinese demand, the RBA should have some good things to say about jobs and maybe even the economy.
The New Zealand government’s decision to chose Adrian Orr as the country’s new central bank governor triggered a sharp and aggressive short squeeze in NZD/USD this past week. Investors like that Orr is an old pro with extensive monetary policy and investment experience. As reported by our colleague Boris Schlossberg, Orr is a “former deputy governor and chief economist at the RBNZ. He currently runs the New Zealand government’s sovereign wealth fund which has returned 16.2 percent per annum over the last five years….. While Mr. Ott is neither a dove or a hawk, investors were reassured that he will keep the monetary policy on an even path restraining the worst impulses of a stimulatory monetary policy.” Gains in NZD were compounded by the improvement in manufacturing activity, the first in 3 months.
Last but certainly not least, USD/CAD ends the week not far from where it started but Friday’s reversal puts the pair back on track for a move to 1.30. The end-of-week reversal was driven entirely by the U.S. dollar’s reaction to progress on the U.S. tax bill (Senators who previously said they voted no are starting to switch sides). The day before, the loonie soared after Bank of Canada Governor Poloz said he is increasingly confident that less stimulus is needed over time. Poloz felt the economy is close to reaching full capacity and while uncertainties remain, necessitating cautiousness on rates, his view on less labor-market slack and early signs of firms offering higher wages puts rate hikes next year back into play. The Canadian dollar will be in focus next week with inflation, retail sales and GDP scheduled for release. We are looking for stronger numbers all around, which could extend the rise in the currency.