How Long Can Dollar And Pound Defy Fundamentals?

By Kathy Lien, Managing Director of FX Strategy for BK Asset Management.

There was very little consistency in USD’s performance this week with the greenback trading lower versus the yen and steady against all of the other major currencies except for sterling. On a percentage basis, the changes were small but given how far the dollar had rallied at the start of the week, the pullback was significant. USD/JPY ran as high as 114.95, just a few pips shy of 115 before ending the week below 113. The most phenomenal part of the move was that it was counter to data and Fed speak. Nearly all of this week’s most important U.S. economic reports beat expectations including consumer prices, retail sales, the Empire and Philadelphia manufacturing surveys, building permits and jobless claims. The only miss was in industrial production and housing starts. Most importantly, Fed Chair Janet Yellen made her intention to raise interest rates very clear. Going into her semi-annual testimony on the economy and monetary policy this week, some investors expected less enthusiasm from the Fed Chair in light of slower earnings growth and a higher unemployment rate. But instead, Yellen remained committed to the central bank’s plans for tightening and said, “waiting too long to tighten would be unwise.” She also indicated that rate increases (plural) in 2017 is appropriate and that “every FOMC meeting is a live meeting”. And while that sentiment was shared by nearly all of her colleagues, the dollar fell after her testimony.

There is no fundamental explanation for the reversal in the greenback but corrective forces emerged as the dollar took its cue from U.S. yields. This misalignment can’t last for long but aside from Fed speak, there’s not much on next week’s shortened U.S. calendar to help the dollar. U.S. markets are closed on Monday for Presidents Day. So while we believe that it is only a matter of time before the dollar resumes its rise, the bulls could be hanging back until President Trump announces his “phenomenal tax plan.”

Sterling was another currency that completely defied fundamentals. Nearly every piece of U.K. data released this week was weaker than expected and while sterling slide against the greenback, the decline was nominal as GBP/USD traded within a narrow 1.2550 to 1.2385 range. However with inflation falling in January, average weekly earnings growth slowing and retail sales turning negative, it will be difficult for the Bank of England to maintain its optimism. We may finally be seeing the effects of Brexit and it shouldn’t be long before 1.2385 support in GBP/USD gives. The UK’s economy now finds itself in the unenviable position of having stagnating wages but higher inflation, which is likely to put further financial stress on households. Despite robust labor demand, the Markit Household Finance Index fell sharply to 42.5 from 43.6 the month prior — the worst drop in 3 years. Clearly, UK consumers are having a difficult time keeping up with cost-of-living increases and their debt is the highest in Europe. All of which makes it much less likely that the BoE will even consider tightening rates in 2017 as the economic conditions are less robust than they appear. Public-sector finances and revisions to fourth quarter GDP are the only U.K. economic reports scheduled for release next week but a quiet calendar may not stop U.K. fundamentals from driving GBP/USD flows. If the pound breaks below 1.2350, the door is wide open for a drop to 1.2200.

While euro ended the week unchanged against the U.S. dollar, its inability to break above 1.0700 is a sign of persistent weakness. Like the U.K., the Eurozone reported mostly softer data. Investor confidence in Germany declined according to the ZEW survey, fourth-quarter GDP numbers was revised lower, Eurozone industrial production dropped more than expected and the current account surplus narrowed. The benefits of a weaker currency are beginning to fade, which explains why the ECB remains cautious. According to the minutes released this past week, there was widespread support for a steady policy stance. With multiple elections happening in the Eurozone and the uncertainty surrounding the current US presidential administration, the central bank felt the need to maintain easy monetary policy. Concerns regarding inflation were also downplayed during the meeting with the recent increase attributed to rising and volatile energy prices. For the time being, the central bank still does not see enough evidence that prices are trickling down to goods and services. The central bank remained cautious overall, mentioning that the economy might hit a speed bump (which is what we are seeing now) and left the door open for more stimulus if necessary. Unlike the U.S. and U.K., there are a number of important Eurozone economic reports scheduled for release in the coming week — the February PMI reports, the German IFO report and consumer prices. Chances are, these releases will be softer, putting more pressure on the EUR/USD.

All 3 of the commodity currencies ended the week marginally lower versus the greenback, some of which had to with soft data. No major economic reports were released from Canada, but nearly all of the key economic reports from Australia and New Zealand were disappointing. The main focus for Australia was labor data. While there was an increase of 13.5k jobs in January and the unemployment rate dropped to 5.7%, more than 44K full-time jobs were lost at the beginning of the year. Which means that the increase in employment was due entirely to part-time work, which rose by 58.3k. This unhealthy mix of job growth worried investors, especially as Chinese foreign direct investment declined by 9.2%. New Zealand also reported lower retail sales, weaker manufacturing activity, a drop in consumer confidence and in house sales. Looking ahead, the new trading week starts with the release of New Zealand’s PMI services report and producer prices. There are no Australian economic reports on the calendar but RBA Governor Lowe speaks on Wednesday and Friday local time. Canada has the most market-moving releases with retail sales and consumer prices on tap. All 3 commodity currencies are due for a deeper correction and we could see that in the coming week.

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