By Kathy Lien, Managing Director of FX Strategy for BK Asset Management.
End-of-week profit taking prevented the U.S. dollar from extending its gains on Friday despite stronger-than-expected first-quarter U.S. GDP growth and an upward revision to the University of Michigan’s consumer confidence index. With that in mind, steady growth and rising inflation expectations should foster further gains in the dollar next week as investors are convinced that the Federal Reserve will use the May meeting to prepare the market for a June hike. Every U.S. policymaker who has spoken this month was in favor of more tightening. Traders should expect the dollar to continue to drive currency flows in the week ahead. There’s a Federal Reserve meeting on Wednesday and nonfarm payrolls report on Friday. Having just raised interest rates at their last meeting, the Fed has no plans to follow up in May but Fed fund futures show a 93% chance of a quarter point rate hike the following month when economic projections are updated and Jerome Powell holds a press conference. U.S. policymakers have been vocal about their desire to raise interest rates at least 3 times this year and the data improvements since the last policy meeting gives them the confidence to take action in the summer. Central bankers always prefer to minimize volatility on the day that a policy change is made, so if the Fed is serious about a June hike, it will signal its intention at Wednesday’s meeting, which would send the dollar even higher.
However if they don’t commit to a rate hike and instead express concerns about the rise in yields and its impact on financial market conditions, the dollar will fall quickly and aggressively as investors are heavily positioned for hawkishness. USD/JPY, which could hit 110 before the rate decision, would sink back to 108. Since there is no press conference, for the dollar to hold onto and extend its gains, the FOMC statement needs to be unambiguously positive. Meanwhile, don’t expect as big of a reaction to this month’s nonfarm payrolls report because it will be released after FOMC and only be used to confirm or challenge the central bank’s guidance. Investors should also keep an eye on U.S. yields as they will determine if the dollar extends its gains ahead of the Fed meeting.
The euro simply couldn’t overcome the dollar’s strength this past week. The single currency closed in on its 4-month low on Friday despite stronger Eurozone confidence, healthy German labor data and optimistic comments from European Central Bank President Mario Draghi. The problem for the euro is that the ECB is expected to trail behind the Fed, so if the U.S. central bank is hawkish, the EUR/USD could break 1.20. While the euro will take its cue from the market’s appetite for U.S. dollars, investors will be eager to see if the inflation and GDP reports show the improvement that Draghi is noting.
Meanwhile, sterling fell to a 1-month low against the U.S. dollar on Friday following a softer first-quarter GDP report. The U.K. economy expanded by only 0.1% in the first quarter causing year-over-year growth to slow to 1.2%, its weakest level in 5 years. This report validates Bank of England Governor Carney’s concern that the market was getting ahead of itself with BoE's expectations for a May rate hike. Since his speech just over a week ago, the odds of tightening in May have fallen from 90% to 24%. In the week ahead, investors will be watching the PMI reports to see if there have been any improvements that could validate the 2 dissenting votes that favored a rate hike at the last meeting. If the PMIs continue to miss, GBP will fall further but if the tide starts to turn and manufacturing- or service-sector activity recovers, sterling will rebound as rate-hike expectations adjust again.
After selling off sharply this past week, all 3 commodity currencies rebounded on Friday with the Australian dollar leading the gains. AUD shrugged off a weaker producer price report, which wasn’t a surprise after Monday’s lower CPI report. The New Zealand dollar stabilized despite an unexpected trade deficit caused by a jump in imports and a surprisingly large drop in consumer confidence. The Reserve Bank of Australia also has a monetary policy announcement and in contrast to the Federal Reserve, the latest inflation reports give the RBA reason to remain dovish. There’s no RBNZ meeting but data has taken a turn for the worse since the last policy meeting with inflation falling to the bottom of the RBNZ’s target so the downtrend for both currencies should remain in tact.
In contrast, the Canadian dollar could experience further gains in the week ahead. Although USD/CAD hit a high of 1.29 this week, it rejected that level on the prospect of a NAFTA deal and less dovish comments from the Bank of Canada. At their last policy meeting, BoC Governor Poloz and Deputy Governor Wilkins outlined their dovish bias but their tone seems to have changed this past week. In a speech to the Financial Committee, Poloz said inflation is on target and the economy is close to potential. With a NAFTA deal imminent, we expect the Canadian dollar to outperform in the week ahead as long as GDP, the trade balance and IVEY PMI reports don’t disappoint in a significant way. USD/CAD will be affected by the U.S. dollar’s reaction to FOMC and NFP but on a relative basis, it should outperform EUR, AUD, NZD and possibly the JPY.