By Kathy Lien, Managing Director of FX Strategy for BK Asset Management.
This past week, many major currencies climbed to fresh multi-month and multi-year highs against the U.S. dollar. The Australian dollar and British pound were the best performers, adding 1% to their gains. The euro, Canadian dollar and Japanese yen lagged behind but still managed to eek out small profits in what became the fifth consecutive week of declines in the Dollar Index. There wasn’t much in the way of U.S. data but the showdown in Washington kept investors out of the U.S. dollar. Looking ahead, we’ll know how everything plays out by Monday with the outcome of the dual political risks in U.S. and Germany determining how currencies will trade in the front of the week. EUR/USD will be the biggest mover as not only do the ramifications of these events directly affect it but there’s also a European Central Bank monetary policy meeting on the calendar. Commodity currencies are finally looking tired after a relentless uptrend this past month that saw very little corrections. We could easily see a cent pullback in the AUD/USD and NZD/USD on nothing more than profit taking.
Based on the White House’s press briefing on Friday, the Trump administration is bracing for a government shutdown. This would be the first government shutdown in 4 years. Despite repeated threats during the Obama administration, the last time the U.S. government was officially shut down was on October 2013, for 16 days. The dollar declined as it has now in the month leading up to the shutdown. Then halfway through, it bottomed out as investors moved on. When Congress passed the Continuing Appropriations Act of 2014 that suspended the debt limit until February, the dollar index actually extended its losses before bottoming a week later. More importantly, the government shutdown didn’t have a major impact on the economy as retail sales or non-farm payrolls rose strongly in the 2 months that followed. So while the dollar should gap lower on Sunday if the government officially shuts down, it will not be a long-term factor that drives the dollar lower. This past week’s U.S. economic reports were disappointing with consumer confidence slipping, housing starts and building permits falling, manufacturing activity in the NY and Philadelphia regions slowing but the Federal Reserve still believes that 2018 will be a stronger year for the economy. Kaplan, who is not a voting member of the FOMC said the base case is for 3 hikes in 2018 while Mester, who is a FOMC voter, favors 3 to 4 hikes. Even uber dove Evans squawked like a hawk. A recovery in the dollar is likely once Powell takes over as Fed Chair. There are no major U.S. economic reports scheduled for release next week until Friday when fourth-quarter GDP numbers are due.
The euro faces two major tests in the days ahead that will determine whether 1.23 is the top or the precursor to a stronger move to 1.25. On Sunday, Germany’s Social Democrats will vote on forming a coalition with Angela Merkel’s government. If the vote fails, EUR/USD will crash and we’ll be talking about a move below 1.20. If it succeeds, 1.23 will be broken but the gains could be short-lived ahead of the European Central Bank’s monetary policy announcement. The first test for the euro is the SPD vote, the second will be Mario Draghi’s press conference. The initial rally in EUR/USD this month was sparked by the account of the last ECB meeting, which revealed policymakers are open to tweaking their guidance in “early 2018” if reflation continues. But after a 4-cent rise since that report and a 5-cent move since the last meeting, European officials are growing concerned about the rapid moves in the currency especially in light of the 25bp increase in 10-year German bund yields. All of this is akin to a rate hike and if the ECB wants to avoid further run up in yields or rise in the currency, the best thing for Mario Draghi to do is to join the chorus of central bankers jawboning the currency and downplay the chance of a change in guidance by stressing that rate hikes won’t be coming until after QE ends. With that in mind, there’s no question that the economy has improved since December but inflation is still low and business confidence has fallen. So if Draghi emphasizes the improvements in the economy over everything else, it would be a testament to their optimism and their willingness to withstand further euro strength and in that case, EUR/USD could squeeze as high as 1.25. In addition to the political risk and ECB meeting, the Eurozone calendar is packed with market-moving event risks such as January PMIs, the ZEW survey and IFO reports.
After seven straight days of gains, we’ve finally seen a pullback in sterling. It took a softer retail sales report to turn the currency around as GBP/USD tried to make a run for 1.40. Over the past month, we seen significant gains and while we believe there will be further gains in 2018, the currency pair is due for a correction. Prime Minister May received the votes she needed to approve the key European Union (withdrawal) Bill and despite European Commission President Juncker’s hope that Brexit will be reversed, 2018 will be the year that a deal gets done. The Spanish and Dutch have already thrown their support behind a soft Brexit and UK officials will be operating under that assumption. In the meantime, as debates and negotiations continue, UK data has taken a turn for the worse with consumer price growth slowing year over year and retail sales taking a nosedive in December. Excluding auto purchases, retail sales experienced its largest decline in 7 months. This does not bode well for next week’s fourth quarter GDP report as spending slowed in the last 3 months of the year. UK labor market data is also due for release and investors will be eager to see if wage growth also weakened. The prospect of softer wage data (after last month’s strong rise) leads us to believe that GBP/USD could slip down to 1.37.
The Australian, New Zealand and Canadian dollars are also primed for a turn. We haven’t seen a meaningful correction in the Australian and New Zealand dollar over the past month and this past week, both currencies hit fresh 3-month highs on the back of stronger data. For Australia, job growth continued at a healthy pace and in New Zealand, dairy prices increased for the second auction in a row. Chinese growth also beat expectations. However with manufacturing activity slowing and price pressures likely to be hit by lower food and dairy prices in the fourth quarter, the New Zealand dollar is at greatest risk for a deep correction that could take NZD/USD down to 71 cents. There are no major Australian economic reports scheduled for release but AUD/USD, which broke but and rejected 80 cents, could drop down to .7850. Much of that hinges on the market’s appetite for U.S. dollars next week but the odds of a correction outweigh the chance of continuation.
The Bank of Canada raised interest rates by 25bp and instead of extending the CAD lower, it halted the slide in USD/CAD. This had nothing to do with the central bank’s guidance as BoC Governor Poloz described the decision as a "no brainer." Instead, after falling sharply into the monetary policy announcement, Canadian dollar traders took profits following the hike as they expect the central bank to hold rates steady at the next policy meeting. Although the BoC expressed concerns about wages and the risk of stalling the expansion by raising rates too quickly, they also felt that tightening too slowly would risk an inflation buildup. Poloz said a rate hike today would validate what they’ve seen in the market and while he can’t say how much accommodation is needed the economy is likely to warrant higher rates over time according to the policy statement. With that in mind, NAFTA is a big risk that they need to monitor closely. Looking ahead, we expect USD/CAD to recapture 1.25 but sellers should emerge between 1.26 and 1.2650. Canadian retail sales and consumer prices are due for release next week – softer numbers are expected after last month’s strong gains.