By Kathy Lien, Managing Director of FX Strategy for BK Asset Management.
Investors don’t need to look any further than the Trump Administration’s failed bid to repeal Obamacare for an explanation as to why the U.S. dollar got crushed Tuesday. A setback for Trump means a setback for the greenback as it casts doubt on the Administration’s broader strategies. The Republican Party has been divided by health-care reform and while party leaders hope they will be unified by tax reform, there’s resistance from the conservative House Freedom Caucus, which wants broader spending cuts and more details on tax reform. Of course with mid-term elections coming up next year, the Republican party is motivated to get something done by December. Chances are that progress on tax reform will be slow, with many challenges along the way, which opens the door to further dollar weakness. U.S. data continues to miss (the NAHB housing market index dropped to its lowest level 8 months), investors are growing more skeptical of fiscal reform and Treasury yields fell sharply on Tuesday. As a result, USD/JPY could drop to 111.00-110.50, EUR/USD should test its May 2016 high of 1.1616 and USD/CHF should break 95 cents. Housing starts and building permits are scheduled for release on Wednesday and they are expected to rebound, which could help the dollar but that won’t be enough to reverse the market’s attitude toward the greenback.
Euro rose to its strongest level in 14 months on the back of short covering and U.S. dollar weakness. This was the third day of gains for the currency, which puts EUR/USD up 10% year to date. The Euro is the best-performing currency in 2017 with the move driven by data, positioning and the market’s shifting outlook for the U.S. dollar. There’s no doubt that European Central Bank President Draghi will be hammered with questions about the currency and its impact on inflation and the general economy. Germany is entering a period of uncertainty with the ECB thinking about shifting policy and the federal election scheduled for September. This explains why the ZEW survey fell for the second month in a row. Investors are growing nervous about what could transpire over the next few months and the strong rise in the euro isn’t helping. However if we look slightly longer term over 5 years for example, EUR/USD is trading closer to its lows near 1.04 than its highs near 1.40. So the ECB could lean either way – it could focus on preparing the market for taper or ease the uptrend by emphasizing the need for continued policy accommodation. For the time being, the market thinks it will be hawkish and with EUR/USD breaking above 1.15, the next stop could be the 2016 high near 1.1616.
Tuesday's best-performing currency was the Australian dollar, which rose to a 2-year high versus the U.S. dollar. Tuesday's 1.6% rally was the strongest move we’ve seen in AUD in months. The U.S. dollar is falling, commodity prices are rising but it was the RBA’s optimism that sent the currency soaring. According to the minutes from the last central bank meeting, the RBA believes that the strong labor market removes some of the downside risks in wages and the quarterly economic growth most likely increased in Q2. They made no mention of a rate hike but its neutral stance was enough to satisfy the bulls. Technically, the next stop for AUD/USD should be the 200-month SMA near 0.7980 but AUD traders need to keep a close eye on the speeches by RBA officials this week as Heath, Debelle and Bullock could use these opportunities to talk down the currency. NZD also rose in sympathy with AUD, climbing to its strongest level in 5 months versus the U.S. dollar. Dairy prices rose 0.2%, which is too small for investors to forget about all other data disappointments. The Canadian dollar, on the other hand, continued to march higher, rising to its strongest level in more than a year. It shouldn’t be long before USD/CAD hits 1.25.
Last but certainly not least, the only currency that underperformed the U.S. dollar was sterling. As soon as members of the Bank of England started talking about removing stimulus, investors questioned their resolve. With consumer prices stagnating in June, it is hard for anyone to believe that the BoE will raise interest rates this year, let alone in August. The year-over-year inflation rate slowed to 2.6%, the first pullback since October. If retail sales also miss, GBP/USD could drop the 1.28 handle.