By Kathy Lien, Managing Director of FX Strategy for BK Asset Management.
This past week turned out to be good for the U.S. dollar as the greenback was steady or stronger against most of the major currencies. While this move came as a surprise to many investors after disappointing U.S. data, it is important to realize that the largest gain — USD/JPY — was only 1%. Although the service sector expanded at its slowest pace in 6 years, Treasury yields rebounded strongly, providing the catalyst for the dollar’s recovery. According to the Federal Reserve’s Beige Book report, several districts reported modest price gains and most districts reported a “modest” or “moderate” growth pace. They also felt that despite weak job growth in August, labor-market conditions remain tight in most districts and wage pressures increased further. On Friday FOMC voter Rosengren confirmed that the economy is performing quite well with the labor market at or close to estimates of full employment. He sees inflation slowly returning to their 2% goal and believes there are risks from waiting too long to tighten. Yet the one-way dollar move was stifled by FOMC voter Tarullo who said he is in the show-me camp, which means he wants to see improvements in data before supporting a rate hike, especially since the ISMs “suggests some grounds for questioning.” With that in mind, he also feels that consumer spending has held up well and “we have an opportunity to continue to get job gains.” Fed President (non-voter) Kaplan believes that the case for tightening has strengthened in the last few months and agrees with Rosengren that there’s a cost to rates at this low level. The main takeaway from all the comments is that despite slower job growth and weaker manufacturing and service-sector activity, U.S. policymakers still believe rates should rise and this consistent message has not been lost on investors.
Looking ahead, we have U.S. consumer spending, inflation and manufacturing-sector reports scheduled for release. We are looking for slightly softer numbers but these reports are not due until Thursday and Friday so the dollar could extend its gains in the front of the week. The big question now is whether the Fed’s optimism will lead to a September rate hike and we don’t think that will be the case so a move to 103.50 to 104.00 in USD/JPY would create an attractive opportunity to sell the rally. With that in mind, we also believe the dollar could extend its gains, particularly versus the euro, British pound and Australian dollar in the front of the week.
The EUR/USD’s price action at the end of last week suggests that investors are still worried about more ECB easing. While European Central Bank Governor Mario Draghi expressed more confidence about the outlook for the Eurozone economy, using the word ‘resilience’ on numerous occasions, their lowered growth forecasts and the announcement of Eurosystem committees to further evaluate stimulus options resonated more with investors. Eurozone data was disappointing with service-sector activity slowing, industrial production plunging and the trade surplus falling. Looking ahead, we have the German ZEW survey, Eurozone trade balance and consumer price reports scheduled for release but none of these releases are major market movers for the euro. Instead we expect the single currency to take its cue from the market’s appetite for U.S. dollars. The recent decline has taken EUR/USD to the 50-day SMA right above 1.1200. If this level is broken in a more meaningful way, we should see a drop to 1.1130 — a correction to this level is probable. It is also worth mentioning that the Swiss National Bank meets next week. No changes are expected as they have done a pretty good job of keeping the Swiss franc from appreciating significantly, allowing GDP growth to accelerate to 0.6% from 0.3% in the second quarter.
The main currency to focus on will be the British pound. Not only do we have a monetary policy announcement from the Bank of England but inflation, employment and retail sales will be released before the rate decision. Recent economic data from the U.K. has been good with manufacturing and service-sector activity accelerating. These reports show that so far the impact of Brexit has been limited. Even Bank of England Governor Carney recognized the signs of stabilization in the U.K. economy with the financial system sailing through the Brexit vote. Data has been “a bit stronger” than they forecast and in response, the BoE reduced the probability that Brexit risks will materialize. Carney also warned that all elements of stimulus could be increased. Monetary policy committee members Forbes confirmed there could be a case for additional easing in the future and Cunliffe said he’d vote for a cut if demand is weaker than thought. So while recent data is putting the central bank’s mind at ease, they stand ready to act if the economy U-turns. Looking ahead, we expect the trend of positive economic reports to continue, which means sterling should outperform other currencies.
The Australian dollar will also be in play with labor data scheduled for release and speeches from a number of Australian policymakers. The sharp sell-off in U.S. equities at the end of last week stripped the Australian dollar of its beginning-of-the-week gains and left the currency in negative territory. The Reserve Bank of Australia left interest rates unchanged citing “recent data suggest that overall growth is continuing, despite a very large decline in business investment, helped by growth in other areas of domestic demand and exports. Labour-market indicators continue to be somewhat mixed, but suggest continued expansion in employment in the near term.” Their neutral monetary policy bias should have been positive for the currency but risk appetite and the recovery in the dollar overshadowed the RBA. Investors shrugged off weaker-than-expected second-quarter GDP growth and stronger trade numbers but looking ahead it may be difficult to ignore the employment report. The market expects a relatively robust gain of 15K new jobs on top of the 27K new jobs generated in July but according to the latest PMI readings from the Australian Industry group, all three sectors – manufacturing, construction and services — are deep in contraction territory having fallen by as much as -9.5 points in just one month. What’s even more troubling is that employment sub-indexes of all three reports are well below the 50 boom/bust line suggesting that at best, the labor report next Wednesday will miss its mark, and at worse could show a net job loss for the month. As such, we expect further losses for AUD.
Chinese industrial production and retail sales numbers are due at the start of the week and these reports could impact the Australian and New Zealand dollars. Dairy prices continue to rise helping NZD outperform AUD. In the week ahead our main focus will be on the second-quarter GDP numbers, which should be stronger, paving the way for a further rally in the New Zealand dollar. We would not be surprised and indeed expect AUD/NZD to fall to fresh year-to-date lows.
There was a lot of data from Canada last week and virtually none in the coming week. On Friday we saw job growth rebound in August after falling sharply in July. Part-time work recovered while full-time jobs declined. The report should have been positive for the Canadian dollar but many investors viewed it as “payback” for the previous month and instead focused on the uptick in the unemployment rate and drop in oil prices. With the decline in oil and rise in the U.S. dollar, USD/CAD soared above 1.30 as the loonie gave up all of its beginning-of-the-week gains. The Bank of Canada left interest rates unchanged with the central bank noting that inflation risks have tilted somewhat to the downside and economic growth may be lower than in July, which may be a nod to the drop in IVEY PMI. Looking ahead, oil prices and the market’s appetite for U.S. dollars will determine how USD/CAD trades.