By Kathy Lien, Managing Director of FX Strategy for BK Asset Management.
Its time to turn your focus to the British pound because on Thursday, the Bank of England will release its Quarterly Inflation report followed by a monetary policy announcement. They are not expected to change interest rates but changes to their economic projections and the overall tone of the report will have a significant impact on the currency. Sterling dropped to a 2-month low versus the U.S. dollar Tuesday as the BoE’s Inflation report and Governor Carney’s comments will determine whether the currency falls through its August lows or turns higher from here.
Based on the persistent decline in GBP/USD, investors are bracing for the worst. While the following table shows widespread deterioration in the UK economy since the September meeting, it is important to realize that overall, the economy is doing well. The unemployment rate is low, inflation is well above the central bank’s target and wages are on the rise.
The last time the Quarterly Inflation report was released, the central bank also raised interest rates but at that time, sterling crashed because the central bank made it clear that they had no plans to tighten again as Carney talked about the scenarios that would require a rate cut if Britain failed to reach a deal with the European Union. Fast-forward 2 months and the UK is still no closer to an agreement. They are beyond the critical period of negotiations, which means Carney will be even more worried about the downside risks. As a result, traders cannot count on the central bank to rescue the pound because they’ve made it clear that the outlook for the UK economy hinges on Brexit negotiations. If the central bank cuts its economic projections or Carney spends a good part of his press conference talking about the possibility of easing, GBP/USD will drop to to 1.26 and EUR/GBP will head toward 90 cents. However if they downplay recent data deterioration and focus on the upside risk of inflation, the heavily sold GBP will reverse quickly as short covering takes GBP/USD back above 1.2850.
Meanwhile, the U.S. dollar traded higher against all of the major currencies except for the Australian and New Zealand dollars. Stronger-than-expected consumer confidence helped sustain the greenback’s gains but the bulk of the rally occurred well before the data was released. Instead, it was the uptick in US bond yields, softer Eurozone data and BoE concerns that prevented EUR, GBP and JPY from rallying. The recovery in US stocks Tuesday was strong but the late-day move was not driven by the consumer confidence index, which hit an 18-year high. Consumers may be optimistic about jobs and the economy but with the slide in stocks deepening, their optimism is expected to sink as well. With that in mind, nonfarm payrolls are scheduled for release this week and economists are looking for a strong post-hurricane rebound. The prospect of a strong jobs report should carry the dollar higher, particularly against the Japanese yen and Swiss franc. Now that USD/JPY has closed above the 20-day SMA for the first time in 3 weeks, the next stop could be 113.50. We don’t expect any major announcements after the BoJ's rate call.
Weaker Eurozone data and German Chancellor Merkel’s decision to step down as chancellor in 2021 has made it difficult for Euro to rally. Not only did Eurozone confidence fall across the board with the business climate, industrial confidence and services confidence slipping but GDP growth also slowed unexpectedly in Q3. Economists had been looking for growth to remain steady at 0.4%, but instead the regional economy expanded by half that amount (0.2%) between July and September. Inflation is still on the rise according to German CPI but the lack of growth makes Draghi’s optimism a hard sell. If Wednesday’s German retail sales and Eurozone CPI reports fail to impress, we could see EUR/USD test its August 1.13 low.
The Australian dollar hit an 8-day high ahead of Tuesday evening’s third-quarter inflation report. Although building approvals were weaker than expected and the Chinese yuan continued to fall, investors are hopeful that China’s attempts to spur demand will provide underlying support to the economy. In an attempt to revive the auto market, China proposed a 50% cut in the tax on car purchases. That follows an announcement earlier this week to lower income taxes and bring down fees for businesses. In the face of growing pressure from the US, China is taking a number of steps to ease the slowdown in growth. While its not clear how much of these tax reductions will help, investors interpreted the policy announcements as good news for AUD and NZD. The inflation report should also help the Australian dollar as the weaker currency and rising inflation expectations signal a potential uptick in CPI. NZD data on the other hand should remain weak as we see no reason for business confidence and activity to improve. Aside from Australian CPI, Chinese PMIs are also due for release. USD/CAD pulled back slightly on the back of BoC comments. Governor Poloz said the economy is operating near its capacity while Deputy Governor Wilkins said wages should accelerate. August GDP numbers are due for release Wednesday and despite the Bank of Canada’s hawkishness, weaker retail sales will prevent GDP from accelerating.