By Kathy Lien, Managing Director of FX Strategy for BK Asset Management.
Next week is Fed Chair Janet Yellen’s semiannual testimony before Congress and the U.S. dollar’s performance tells us that investors are banking on her continued optimism and hawkishness. While Friday’s labor market was mixed, the overall report was good enough for dollar bulls who have turned a blind eye to any negative reports, trusting the Fed. The argument is compelling with all 3 members of the Fed leadership (Yellen, Fischer and Dudley) pointing to improvements in the U.S. economy as reasons for policy normalization. The 222K increase in nonfarm payrolls in June and the upward revision to jobs in May is enough for Yellen to maintain her credibility and justify her positive labor-market assessment. While the unemployment rate ticked up to 4.4% from 4.3%, it has been low for some time so it's not a major concern, particularly since the participation rate and average weekly hours increased. The slowdown in wage growth on the other hand is a bigger problem, especially as earnings in May were revised lower but investors dismissed that as they hope wages will rebound in the months ahead on stronger service and manufacturing activity and the uptick in jobs. As we also believe that Yellen will put on a brave face and focus on the improvements in the U.S. economy, stressing the need for policy normalization at Wednesday’s testimony, the dollar should trade with a firm bias for most of the week. We see USD/JPY making a run for 115 and GBP/USD sinking down to 1.28.
By all counts, it was a relatively good week for the euro. The single currency recovered from earlier losses to end higher against most of the major currencies and only slightly lower against the U.S. dollar. Unlike some other central banks who have been hawkish in the face of mixed-to-deteriorating data, this week’s Eurozone economic reports validated the European Central Bank’s positive views. The manufacturing- and service-sector indices in the Eurozone were revised higher and retail sales increased. In Germany, we also saw factory orders and industrial production rise, reinforcing the recovery in the manufacturing sector and the region’s economy. Looking ahead we expect the euro to be supported by the upcoming German trade balance and Eurozone industrial production reports along with the continued hawkishness of ECB officials. According to the ECB’s account of their last monetary policy meeting released this past week, the “governing council considered whether to adjust their QE easing bias.” They decided against it at the time but this revelation confirms that the central bank is getting ready to taper asset purchases. Even ECB member and Bundesbank President Weidmann agreed that the recovery opens door to ECB policy normalization and Nowotny added that QE is not a permanent policy tool. We often see this type of uniformity in the central bank’s comments when they are trying to prepare the market for a major change in policy and that’s exactly what we think the ECB is doing. As such, we continue to expect euro to outperform other currencies, particularly sterling, the Australian and New Zealand dollars whereas EUR/USD could underperform if the U.S. dollar continues to rise.
In the U.K., softer data cast doubt on the hawkish comments from the Bank of England. Since their last monetary policy meeting, we’ve seen Bank of England Governor Carney join McCafferty, Haldane, Saunders and Forbes in supporting less policy accommodation. That means 5 of the 8 members of the Monetary Policy Committee could vote for a rate hike this year. Three have already done so and it may not be long before Carney and Haldane follows suit but it is difficult to imagine how the UK central bank could seriously consider tightening soon with data consistently falling short of expectations. Service-, manufacturing- and construction-sector activity slowed in June while industrial and manufacturing production turned negative. This along with a stronger pound in May caused the trade deficit to increase. As our colleague Boris Schlossberg noted “The high inflation rate, along with tepid investment flows caused by the uncertainty of Brexit is wreaking havoc with UK growth and the only way that cable could regain its footing is if the government of PM May moves closer to the soft Brexit position, thus mitigating the worst effects of the exit from the union. At present, there is little evidence that Ms. May has the political will to change course and that leaves the currency vulnerable to further selloff especially if the drumbeat of negative economic data gets louder over the next few months.” In the coming week, U.K. labor data is scheduled for release and while claimant count is expected to fall (the PMIs report strong job growth), average hourly earnings growth could slow. If GBP/USD breaks 1.2850, we could see the pair slide as far down as 1.27 while the hawkishness of the ECB could take EUR/GBP to 90 cents.
Meanwhile, this week's best-performing currency was the Canadian dollar, which hit a fresh 10-month high against the greenback. The Bank of Canada meets next week and not only are traders positioning for hawkish comments, but there’s even hope for a rate hike. There’s been widespread improvement in Canada’s economy since their last monetary policy meeting in May with solid job growth translating into stronger consumer spending. On Friday we learned that 45K jobs were added in June, driving the unemployment rate down to 6.5% from 6.6%. Although most of the jobs were part time, the uptick in the participation rate and the fact that Canada did not lose full-time jobs (after adding a whopping 77K in May), reflects labor-market strength. GDP growth and building permits are up and while the IVEY PMI index fell slightly from the previous month, the manufacturing index rebounded sharply in June after pulling back in May. The only serious areas of concern are low inflation and the stronger currency. The Canadian dollar appreciated more than 6% over the past 2 months, increasing the pressure on inflation. For this reason we don’t think the Bank of Canada will raise interest rates next week but they should maintain their hawkish views, which means any relief rally in USD/CAD should be shallow.
The Australian and New Zealand dollars peaked this past week below key resistance levels. For AUD/USD, the key level was 77 cents and for NZD/USD 0.7350. Although most recent Australian economic reports were better than expected, including retail sales, which increased 0.6% (3 times more than anticipated), manufacturing- and service-sector activity accelerated and the trade surplus ballooned, Aussie was faced with heavy selling after the Reserve Bank of Australia left interest rates unchanged. Part of the weakness had to do with the central bank’s ongoing concerns about the strong currency but the main reason why AUD tumbled is because the RBA is not drinking the same Kool-Aid as the central banks who have been so eager to share their hawkish bias. With no major Australian economic reports scheduled for release next week, AUD should continue to underperform other major currencies with AUD/USD resuming its slide. The same is true for the New Zealand dollar, which was hit by lower dairy, house and commodity prices. Card spending and consumer confidence numbers are the only pieces of New Zealand data scheduled for release next week and we believe that 0.7350 resistance in NZD/USD should hold.