Adjusting To The New Monetary Policy Trajectories

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

What was suppose to be a quiet week in the foreign-exchange market turned into an extremely eventful one that saw many major currencies hit new highs against the U.S. dollar. There were a few pieces of market-moving data (mostly from the Eurozone), but currencies were driven exclusively by central-bank speak. Investors were forced to reassess their positions after Bank of England Governor Mark Carney and European Central Bank President Draghi turned hawkish. The U.S. dollar, which experienced broad-based losses, was a casualty of the fresh opportunities presented by new monetary policy trajectories. As incoming data confirmed the optimism of central bankers in Europe and the U.S., data cast doubt on the Fed’s hawkishness leading to a sharp rise in EUR/USD and GBP/USD.

Fed President Bullard — not a FOMC voting member — vocalized the market’s concerns when he said the Fed is raising interest rates against a backdrop of relatively weak growth and downside inflation surprises. However Bullard is the minority as many other U.S. policymakers (including Vice Chair Fischer and FOMC voter Dudley who spoke this week) support Janet Yellen’s positive view of the economy. There were some bright spots in U.S. data as well including the uptick in consumer confidence, smaller U.S. trade deficit, stronger manufacturing activity in the Chicago region, stronger confidence and upward revision to Q1 GDP growth.

Unfortunately these reports were not meaningful enough to prevent losses in the greenback, leaving investors divided on whether a year-end rate hike is truly coming. Before buying what the Fed is selling, they want to see a significant pickup in job growth and stronger average hourly earnings. The next nonfarm payrolls report (due on Friday) will be a crucial test for the greenback and a deciding factor in determining whether EUR, GBP, CAD and other major currencies hit new highs. The Fed minutes should be hawkish but NFPs are the main focus. We expect USD/JPY to trade in a 110.50-113 range ahead of the jobs report and to breakout if the data impresses — or disappoints in a meaningful way.

Meanwhile, the euro is on a tear. It is almost hard to believe that the currency is up 1000 pips, or 10 full cents, since the beginning of the year. The European Central Bank started the year with an extremely accommodative monetary policy stance and it walked into the second half with a completely different attitude. ECB President Draghi hasn’t uttered the word "taper" yet but there’s no question that they are laying the groundwork for removing stimulus. The ECB is an extremely calculating central bank that likes to set expectations for major policy changes months in advance so that when the actual change is made, investors have it fully discounted, making the market impact minimal. Which is exactly what it is doing now. At the very start of last week, Draghi kicked the ball in motion by saying they may change polity to a neutral stance. EUR/USD shot up in response, almost too quickly, prompting the ECB to come out and say that the market misjudged Draghi’s speech. However as he did not confirm this misinterpretation at the central-bank panel a few hours later, investors took the ECB’s comments as nothing more than an attempt to slow the euro's rise. They bid EUR/USD back up in response, sending the pair to a 1-year high. As Eurozone data continues to support the ECB’s hawkishness, it won’t be long before 1.15 is in the rear-view mirror.

The most surprising shift came from Bank of England Mark Carney who only weeks ago raised concerns about low wage growth. At the ECB forum in Sintra, Portugal this past week, he said “some removal of monetary stimulus is likely to become necessary if the trade-off facing the MPC continues to lessen and the policy decision accordingly becomes more conventional.” These words caught the market off guard and took GBP/USD above 1.30 in a week with no losses. Looking ahead, GBP has 2 things going for it: the first is the BoE’s hawkishness and the second is Prime Minister May’s survival of the Queen’s vote. The minority government narrowly defeated Labour, allowing May to keep her job. Next week’s PMI reports will be extremely important in reinforcing the central bank’s hawkishness and the rise in sterling. If manufacturing- and service-sector activity accelerates, we should see GBP/USD close above this year’s high of 1.3050.

With USD/CAD dropping to 1.30, many traders are wondering how much further the currency will fall. Like the euro, loonie has the support of data and policy guidance. In mid June, Bank of Canada Deputy Governor Wilkins set the loonie on an upward course when she said they may need to assess whether less stimulus is needed. This past week, Deputy Governor Patterson explained that the central bank is less dovish because they feel that the economic shock from oil is largely behind them. We haven’t heard much from Poloz who had multiple opportunities to address policy, so investors interpreted his silence as an endorsement of hawkish views. Yet it may be difficult for the positive trend of Canadian data to continue in light of the big improvements seen the previous month. Canada’s trade, IVEY PMI and employment reports are scheduled for release and we are looking for softer numbers all around. We’ve already seen GDP growth slow in April. So while USD/CAD is in a strong downtrend, we could see a relief rally back to 1.32 in the coming week.

The Australian dollar, which climbed to fresh 3-month highs, will be in play this coming week. In addition to the latest PMI reports, retail sales and trade balance, the Reserve Bank of Australia also has a monetary policy announcement. When it last met, the central bank expressed concerns about the appreciating currency and weak growth in total hours worked. But their warnings fell on deaf ears as investors focused on the neutral policy stance. Going into this month’s meeting, we’ve seen further improvements in the labor market, a rally in iron ore prices and stronger Chinese import demand but businesses are nervous, home loans are falling and the trade surplus shrank significantly in April. So the central bank has no reason to change its views and if anything, it could express greater concern about the rising currency. With that in mind, there is significant resistance for AUD/USD between 0.7700 and 0.7750. Unlike AUD and CAD, the New Zealand dollar struggled to extend its gains this past week as a smaller trade surplus offset stronger business confidence. With no major economic reports on next week’s calendar, NZD should take its cue from the market’s appetite for U.S. and Australian dollars.