By Kathy Lien, Managing Director of FX Strategy for BK Asset Management.
By all counts September was a strong month for the U.S. dollar. The greenback appreciated more than 2% against the Japanese yen, over 1% versus the Swiss franc and Australian dollar and about the same amount against the euro. The only currency that saw meaningful gains against the dollar was sterling, which caught a strong bid after the Bank of England turned hawkish this month. But as we look ahead to October, the greenback’s momentum is fading and the odds of a correction outweigh the chance of continuation. Part of this has to do with the outlook for U.S. data and part has to do with the prospect of other central banks tightening policy over the next 2 months. We’ll dissect each of these in future detail but we fear October will not be as kind to the greenback.
For the U.S. dollar, October is when we will begin to see the negative impact of hurricanes Harvey and Irma on the U.S. economy. Everyone from economists to Federal Reserve officials have warned that data will be distorted temporarily but based on the performance of the dollar and U.S. stocks, investors may not be prepared for the extent of potential weakness in these reports. Yes, the data will recover the following month but nonfarm payrolls are due for release in the coming week and economists are only looking for payrolls to rise by 75K, which would be the weakest pace of growth in 6 months. This follows a steady trend of slower job growth in July and August that questions the hawkishness of the Federal Reserve. When the Fed met in mid September, it made it clear that tightening will continue. Its dot-plot forecast showed a majority of policymakers favoring 1 more hike in 2017 followed by 3 hikes in 2018. However a number of the Federal Reserve officials who spoke this past week did not sound as enthusiastic about raising interest rates and data, including the latest personal income, spending and PCE deflators were softer. We’ll hear from more Fed Presidents in the coming week and perhaps their views will be different. Yet even Yellen’s hawkish comments failed to lift the currency. Part of the problem is that while the Fed plans to raise interest rates, the market doesn’t expect it to do so until December — and a lot can change between now and then. U.S. data may not recover as strongly or it may, but either way there’s plenty of time for investors to position for hike as December nears. For now the focus will be on the prospect of softer data and the promise of tighter policy in Europe, which is negative for USD/JPY and USD/CHF and positive for EUR/USD and GBP/USD.
One of our favorite currencies in the weeks ahead is the euro. On a fundamental basis the outlook for the Eurozone is positive. According to the most recent economic reports, inflation and retail sales activity improved in Germany, the Eurozone’s largest economy. The uptick in activity hardens the central bank’s resolve to normalize monetary policy in October. ECB President Mario Draghi made it clear this past week that the bulk of QE decisions will be made in this month. Although he also added that they have to be sensitive about not halting the recovery and careful about hasty moves, if data continues to improve, their announcement to taper will be accompanied by plans for more changes in the coming months. The week started with election uncertainty but the euro has finally stabilized as investors realize that at the end of the day, Angela Merkel will still be leading the country. It won’t be long before a coalition government is formed and EUR/USD traders could celebrate the announcement by driving the currency higher on the elimination of election uncertainty. Technically, EUR/USD found support this past week right at 1.1720. This level is significant and a prime place for a bottom as it is where the 200-week SMA converges with the 23.6% Fibonacci retracement of the 2008 to 2016 sell-off as well as the 38.2% Fib retracement of the 2014 to 2016 decline. No major Eurozone economic reports are scheduled for release in the coming week.
In contrast, all 3 of the U.K.’s PMI reports are due for release, making it an important week for sterling. The Bank of England shifted the trajectory for the currency when it suggested that rates would need to rise. Since then we haven’t had much in the way of market-moving data although second-quarter GDP was revised lower and mortgage approvals increased by a smaller amount in August. Next week’s PMI reports will be exceptionally important. If manufacturing, service and construction activity accelerate, it would validate the BoE’s calls for tightening and reinvigorate the rise in pound sterling. However if manufacturing- and/or service-sector activity slows, it would cast doubt on the central bank’s plans and cause the currency to give up some of the gains that it enjoyed in September against the dollar and the euro. Bank of England Governor Carney spoke last week and while his speech was highly anticipated, he shed no new light on the central bank’s policy plans. EUR/GBP fell sharply in September and is prime for a relief rally. If the PMIs disappoint, we could see the pair break back above 89 cents.
The new week will also be an important one for the Australian dollar with a Reserve Bank monetary policy announcement on the calendar along with retail sales, the trade balance and PMIs. The Australian dollar has traded lower ahead of the rate decision as investors anticipate more cautiousness from the central bank. This would be a departure from RBA Governor Lowe’s view back in September when he said lower rates would add to risk in household balance sheets, sending AUD/USD sharply higher. However data has taken a turn for the worse over the past month with consumer and business confidence falling, GDP growth slowing, inflation expectations declining and service-sector activity slowing. copper and iron-ore prices have also fallen sharply and China is slowing on Standard & Poor’s recent downgrade. There’s very little for the RBA to be excited about and for this reason it could emphasize the challenges that the economy faces over the prospects for growth. If that’s the case, AUD/USD will extend its losses. But if RBA focuses on its expectations for a gradual pickup in activity and rise in inflation, AUD/USD could find its way back toward 80 cents.
The New Zealand dollar, on the other hand, completely shrugged off the Reserve Bank of New Zealand’s cautious monetary policy outlook. Interest rates were left unchanged and in its statement the bank specifically said that headline inflation will decline in the coming quarters and for that reason policy will remain accommodative for a considerable period. These dovish comments should have driven NZD/USD lower and it did initially but it wasn’t long before the currency bounced off its lows as the U.S. dollar descended from its highs. No major data from New Zealand is scheduled for release next week so NZD will most likely take its cue from the market’s appetite for Australian and U.S. dollars along with the next dairy auction.
Of the 3 commodity currencies, the biggest story this past week was in Canada. Since the last monetary policy meeting, investors have been looking for another rate hike from the Bank of Canada this year. Their expectations were fueled by hawkish comments from Finance Minister Morneau who said Canada can continue to do well at these dollar levels and higher interest rates are expected given the performance of the economy. However Bank of Canada Governor Poloz halted the rally and sent the loonie tumbling when he indicated that another rate hike was not a done deal. The BoC head said there is no predetermined path for Canada interest rates and they won’t be mechanical on rates because inflation and wage growth is slower than they anticipated. They plan to proceed cautiously, which basically means there will be no rate hike in October and a lower chance of tightening in December. The BoC is not happy with the rise in the currency and with supply growth likely to restrain inflation, the mere suggestion that they could be done tightening for the year was enough to send USD/CAD above 1.25. Although USD/CAD recovered those losses, softer GDP growth and the decline in Canadian yields should catch up to the currency. Canadian labor-market numbers are due for release in the coming week along with IVEY PMI report and retail sales.