By Kathy Lien, Managing Director of FX Strategy for BK Asset Management.
U.S. dollar bulls have nothing to be thankful for, as it was a short and brutal week for the greenback. The dollar sold off against all of the major currencies, hitting a 2-month low versus the Japanese yen and a 1-month low versus the euro, Swiss franc and sterling in the process. All of the factors that had previously driven the greenback sharply higher are the same ones that are now driving it lower. USD/JPY experienced the steepest decline followed by USD/CHF while gains in GBP/USD, EUR/USD and AUD/USD were restrained by previous weakness. Looking ahead to a full trading week, many investors are wondering if it will be another difficult one for the greenback. The answer to that question lies in tax reform. The Senate will be back from recess and if there’s no meaningful progress or more GOP deflectors, the dollar could face further losses.
On a fundamental basis, nothing dramatic happened over the past week. The very few U.S. economic reports that were released were mixed with leading indicators and existing home sales rising while durable goods fell. Weekly jobless claims declined while the University of Michigan Consumer Sentiment index was revised higher. The only valid reason for USD's decline was the Federal Reserve’s reservations about inflation. The FOMC minutes revealed that while many policymakers see a near-term hike as warranted, a few also oppos it because of weak inflation. Fed-fund futures were unfazed, which tells us that that investors see all of this impacting only next year’s rate hikes – not the one that has been fully discounted in December. The market is pricing in a 97% chance of a rate hike in 3 weeks but the odds of a first-quarter hike next year fell to 52.7% on Friday from 61% on Monday. Falling yields are a big problem for the dollar and one that can only be corrected by very strong data, unusually hawkish comments and meaningful progress on tax reform.
Unfortunately it is hard to see all that happening in the week ahead with a relatively light U.S. calendar consisting of only new home sales, the trade balance, another consumer sentiment report, GDP revisions, personal spending, income and manufacturing-sector reports. While this is a lot of data, they are not game changers for the Fed. Instead, we’ll have to wait for the next nonfarm payrolls report. What may be more interesting are the speeches by Yellen and Powell. Yellen appears before the Joint Economic Committee while Powell sits before the Senate Banking Committee for his nominee hearing. On tax reform, Congress will be getting back to work but with deep divides within the Senate on key issues, the vote is too close to call. It is unclear whether the Senate is ready to vote on the tax bill next week or if it will be pushed out further. While tax reform seems inevitable, the near term uncertainty will not be good for the currency. On a technical basis, the latest sell-off in USD/JPY has taken the pair below its October low. There’s some near term support at 111 but real support lies closer to 110.
At the start of the week the euro was hit hard by German political troubles but by the end, it faded out of focus and climbed to its strongest level since September 25. Germany’s political troubles have not gone away but so far investors seem to believe that even with another election, Angela Merkel will remain Chancellor. Merkel, the public and the investment community see new elections as the best way forward and while the uncertainty of German politics will remain a threat to the currency, it will be months before an election is held so Eurozone data and U.S. dollar weakness became the primary driver of EUR/USD flows. Stronger Eurozone PMIs and an uptick in the German IFO index sent EUR/USD shooting above 1.19 and now everyone is eyeing 1.20. These numbers show that German businesses are more optimistic as manufacturing activity accelerates. The question of whether EUR/USD breaks 1.20 hinges on the continuation of Eurozone data strength and U.S. dollar weakness. We expect the upcoming Eurozone confidence, inflation and German labor-market reports to highlight the strength of the region’s largest economy but they won’t change the European Central Bank’s monetary policy stance. Since the last monetary policy meeting, ECB officials have taken every opportunity to remind investors that they have no plans to change their policy outlook until late next year. This outlook could lead to the euro’s underperformance but EUR-positive sentiment needs to shift first.
Sterling was supposed to hit a one-month high on the back of Brexit news (Prime Minister May was expected to increase her Brexit-bill offer) but absolutely nothing was announced this week. Instead, Ireland’s border became an unexpectedly significant hurdle to advancing Brexit talks. Ireland fears that Brexit will mean the return of security controls and customs borders and given the significance of cross border trade they are demanding an invisible border. Theresa May agrees that they don’t want to reintroduce a physical border with Ireland but they have been light on details and the Irish government want written assurances and a firm commitment. However the UK government has been slow to do so because that could involve carve outs for Northern Ireland that may require a substantial constitutional change in status without a referendum. At the end of the day however, as long as May is not pushed out of the government she will be motivated to advance the talks and any progress would be viewed as positive for the currency. So while the Office of Budget Responsibility lowered their 2017 to 2020 GDP forecasts, further weakness in the U.S. dollar or sterling-supportive Brexit news could take GBP/USD to 1.34 easily. In the week ahead, the U.K.’s manufacturing PMI report is the most important piece of data on the U.K. calendar and given the sharp rise in industrial orders, there’s scope for an upside surprise that could extend GBP/USD’s rally
Having fallen more than 7% over the past 2 months, the Australian dollar has found a bottom. The sell-off in AUD/USD stopped right at the 100-week simple-moving average just as gold, iron ore and copper prices turned higher. There were no major economic reports released last past week but between RBA Governor Lowe’s comments and the falling U.S. dollar, AUD/USD traders found the perfect excuse to start covering their shorts. After the RBA minutes were released, Governor Lowe said it is more likely that the next move in rates will be up instead of down. While these words ignited a relief rally in the currency, it's also important to realize that the RBA remains firmly neutral as Lowe sees no strong case for near-term adjustment in policy. He’s still worried about low inflation but encouraged that wage growth appears to have stabilized. The RBA minutes were less encouraging as the focus was on the uncertainty surrounding wage pressures and weaker consumption but the central bank governor’s comments allowed traders to shrug off the report quickly. In the coming week, manufacturing PMI reports from Australia and China could have a meaningful affect on the currency.
The New Zealand dollar also enjoyed a nice recovery this past week despite relatively benign data. Retail sales rose 0.2% in the third quarter, which was stronger than the market’s 0.1% forecast. While this growth is hardly impressive, especially after last quarter’s 1.8% rise, the fact that spending increased at all was perceived as good news. But the market’s interpretation was mainly a function of the deeply oversold currency. New Zealand’s economy is not performing well. Despite a higher trade surplus over the past few weeks, we have also learned that consumer spending is soft, dairy prices are falling and manufacturing and services activity slowed from the previous month. These reports won’t sit well with the Reserve Bank of New Zealand, which could express fresh concerns in its Financial Stability Report, scheduled for release next week.
Next week will be an important one for the Canadian dollar, with Q3 GDP, September GDP and November’s labor-market report scheduled for release. USD/CAD drifted lower this week on U.S. dollar weakness although it bounced off its lows following a softer-than-expected retail sales report. Consumer spending grew only 0.1% in September, which was significantly weaker than the market’s 1% forecast. Excluding auto-spending was just as subdued, rising only 0.3%. Recent reports show that the Canadian economy is not faring as well as it had earlier in the year when the Bank of Canada was raising interest rates. On top of that, zero progress was made at the latest NAFTA talks. The upcoming GDP and employment reports could reinforce this view as the latest IVEY PMI index showed a significant slowdown in job growth. Trade activity also deteriorated materially in the third quarter. Softer reports could take USD/CAD back to 1.28 but as all of these numbers are not due until Friday, USD/CAD flows will be driven by the market’s appetite for U.S. dollars.
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