Tough Times Ahead For USD

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

After rising for 4 weeks straight, U.S. dollar bulls have lost control. The greenback sold off against all of the major currencies, losing nearly 2% of its value versus sterling and falling more than 1% against the euro, Australian and New Zealand dollars. For many currencies, this week is significant because it is the first positive one since early September. As we now head into the third week of October, forex traders are wondering if the dollar will resume the downtrend that characterized its move for most of the year and we think it will.

Despite relatively decent U.S. data, the dollar struggled this past week because investors were not convinced that the positive economic reports increase the chance of 3 rate hikes next year. A rate hike in December is almost fully priced in and while the Federal Reserve’s latest dot-plot forecast show policymakers favoring 3 hikes in 2018, Fed-fund futures show only a 70% chance of ONE rate hike in 2018 – and that’s why the dollar has been unable to rise. Although consumer prices increased 0.5% in September, excluding food and energy costs, prices rose only 0.1%, suggesting that disinflationary forces are still at play. Retail sales rose by 1.6%, the strongest amount since March 2015 but excluding auto and gas purchases, spending only increased 0.5%. So in a nutshell these numbers were not strong enough to offset the risks facing the dollar over the next 2 months.

There are 2 main threats hanging over the greenback right now – North Korea and the selection of a new Fed chair. The timing for both is unknown as are the consequences. On North Korea, neither side appears to be backing down and both are suggesting military action so the situation is likely to worsen before it improves posing an ongoing risk for the greenback. As for the Fed chair, anyone but Yellen would be perceived as negative for the dollar and if President Trump selects someone who is not a current member of the Federal Reserve, the damage could be even more significant. The third risk is the state of the recovery over the next 2 months. If we don’t see consistent improvements in job growth, wages, inflation and spending, the last rate hike of the year and probably the last of Yellen’s career at the Fed could be accompanied by cautiousness. This means every incoming economic report will be scrutinized carefully. Looking ahead, the main focus for the dollar in the coming week will be the 2 speeches by Fed Chair Janet Yellen as the Empire State, Philadelphia Fed, industrial production and housing-market reports should only have a limited impact on the dollar. The Beige Book is also due for release and it will tell us how much traction there’s been in the economy.

The European Central Bank’s monetary-policy announcement is less than 2 weeks away. Between now and then, the only thing that investors will be thinking about is whether it will be a hawkish or dovish taper. Based on last week’s mostly better-than-expected economic reports, the ECB should reduce asset purchases and pave the way for tighter policy. However between Spain’s political troubles (which are no closer to being resolved) and the high level of the exchange rate, ECB officials have stressed that policy will remain extremely accommodative, which suggests that their preference for a dovish taper. Who can blame them when they know that hawkish comments will drive EUR/USD to 1.20? However on a historical basis, the euro is not that strong because the 5-year average is 1.2060. As recently as 2014, EUR/USD was trading well above 1.30 and at that time, the annualized CPI rate was a fraction of where it is now. So the ECB could taper and say this is the beginning of a longer period of policy normalization that will carry well into 2018 and if that’s the case, euro will soar. Next week’s German ZEW survey and Eurozone CPI report will help to shape expectations for the ECB meeting but it will take very strong reports to convince the market that the central bank is gearing up for a hawkish taper. As a result, we expect the euro to underperform other major currencies.

Over the past week, sterling has been one of the best-performing currencies. After selling off sharply between the middle of September and the first week of October, the British pound has come roaring back. The prior decline in the currency was driven by the combination of Prime Minister May’s political troubles and a rising dollar. Through this period, investors completely forgot about the Bank of England’s hawkishness. Back on September 14, when sterling was still in a strong uptrend, the BoE revealed that a majority of monetary policy members saw “scope for stimulus reduction in the coming months.” Rate hike expectations shot higher in reaction and while sterling fell sharply days after, those expectations for tightening barely changed. So now that Prime Minister May’s troubles seem to be fading and the EU’s Chief Negotiator suggested that they could provide the 2-year Brexit transition that she’s been asking for, a soft Brexit and prospects of a year end rate hike have returned to take sterling higher. Next week is an important one for the U.K. because there are a number of key economic reports on the calendar that will play a major role in hardening or weakening the BoE’s case for tightening. Inflation, employment and consumer spending numbers are scheduled for release and we are mostly looking for stronger data that should take GBP/USD to 1.34.

The Canadian and Australian dollars experienced their first positive week in a month. All 3 commodity currencies have been hit hard in September into early October and finally enjoyed a much needed mid month recovery. There was no specific catalyst for the reversals outside of U.S. dollar weakness and short covering and for the most part data was mixed with Canada reporting weaker housing data and Australia reporting stronger consumer and business confidence. In New Zealand, confidence also declined. Both AUD and NZD have become deeply oversold so a bounce during a week with little data is not unusual. Looking ahead, fundamentals will come back into play with highly market-moving data on the calendar. Inflation reports book-end the week starting with Q3 CPI from New Zealand and ending with consumer prices from Canada. The Reserve Bank of New Zealand is one of the least hawkish central banks and if consumer prices fall short of expectations, we could see renewed losses in NZD. However if CPI grows even slightly, it would add fuel to the relief rally. Aside from CPI, retail sales are also due for release from Canada. Labor-market conditions took a turn for the worse last month and according to the IVEY PMI report, price pressures declined so while the loonie appears to be fighting hard to maintain strength, it may end up forfeiting any gains at week’s end. For Australia, September labor-market data and Chinese GDP numbers will be the main numbers to watch. According to the PMIs, labor-market activity deteriorated and if that’s true, AUD could give up its gains as well. On a technical basis, the latest recoveries in AUD/USD and NZD/USD have taken both currencies to key technical levels so a correction may be in the cards.