Fed Officials Talk Rate Hike, Investors Dump Dollars

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

Investors dumped U.S. dollars Tuesday, pushing the greenback lower against all of the major currencies. The buck lost approximately 1% of its value versus the yen, sterling, Swiss franc and the New Zealand dollar. Mixed U.S. economic reports contributed to the move but the sell-off began in Asia. USD/JPY broke its 106.68 August low and the selling continued into Europe and North America with the pair flushing down to 99.55 on the back of U.S. data. The primary disappointment was in consumer prices, which stagnated in July. This was expected but excluding food and energy costs, CPI grew only 0.1% compared to a forecast of 0.2%. Year-over-year, CPI growth came in at 0.8% -- the slowest rate this year. Building permits also declined but aside from that, housing starts rose strongly, real average hourly earnings growth accelerated and industrial production surged, rising by the fastest pace since November 2014. Most importantly, Fed Presidents Dudley and Lockhart warned that the market is underpricing tightening and that rates could rise this year. Dudley -- a voting member of the FOMC -- went one step further to say that a hike in September is possible. There’s no ambiguity in where he stand on monetary policy and for that reason, the dollar should be trading higher.

The minutes from the last Fed meeting are scheduled for release Wednesday and given the optimistic tone of the FOMC statement, the minutes should be positive for the dollar. Yet based on USD's price action, investors are not buying what Dudley and Lockhart are saying. They are looking at last week’s soft retail sales report and Tuesday’s stagnant inflation report and using them as arguments for why rates will remain unchanged this year. However Fed-fund future traders have been swayed by the fed Presidents with the market now pricing in a 51% chance of a 2016 rate hike -- up from 45% on Monday. So the only explanation for the dollar's weakness, aside from the skepticism of forex traders, is positioning and the technical condition of the dollar.

Tuesday's best-performing currency was sterling, which rose for the first time in 10 trading days. GBP/USD traders responded positively to the inflation report even though CPI dropped -0.1% in July. On a year-over-year basis, core CPI growth slowed to 1.3% from 1.4% but headline CPI expanded to 0.6% from 0.5%. Input and output prices on the producer level saw broad-based increases and perhaps the fear is that this will filter down to the consumer level. The Bank of England has made it clear that the boost to inflation caused by a weaker currency will be temporary so while the currency responded positively to the report, it is positioning rather than true concern about price pressure that is driving sterling higher. We previously mentioned that short sterling positions are at record highs so the effect of good news could be compounded. On a technical basis, GBP/USD appears poised for further gains, while fundamentally, we expect Wednesday’s labor-market report to be weak with the PMIs showing significant deterioration in employment conditions in the manufacturing and construction sectors. Taking these two factors into consideration, GBP/USD may be a better sell closer to 1.31.

Euro also shrugged off mixed data to trade higher against the U.S. dollar. The region’s trade balance narrowed unexpectedly in August and investor confidence rose less than expected. According to the ZEW survey, investors were more optimistic about current conditions but were worried about the outlook for Germany. Interestingly enough, they were more optimistic about the future of the Eurozone as a whole. While euro ended the day well off its highs versus the U.S. dollar, the break above the 100-day SMA puts momentum clearly on the side of EUR/USD bulls.

All three commodity currencies traded higher against Tuesday's dollar. The weakest was the Australian dollar as the RBA minutes failed to move the needle much. The RBA noted that inflation is expected to remain low, which should help overall economic growth prospects. However the RBA also mentioned that the elevated Australian dollar would cause issues for transition from the mining boom. Although the overall message was mixed, the upbeat outlook of the economic prospects failed to stimulate conversation about a September cut. The New Zealand dollar was the best performer, getting a lift from a strong increase in dairy prices. Labor-market numbers were due Tuesday evening and even though the RBNZ cut interest rates, employment conditions appeared to be stronger in Q2 versus Q1. Meanwhile, the Canadian dollar continued to rally on the back of strengthening oil prices.