By Kathy Lien, Managing Director of FX Strategy for BK Asset Management.
Janet Yellen gave dollar bulls fresh hope on the second day of her testimony to Congress. The Fed Chair finally talked up the improvements in the U.S. economy, reminding everyone they still plan to raise interest rates. The dollar rebounded in response versus the euro and Japanese yen. While the greenback failed to turn higher against sterling and the commodity currencies, it still managed to take these pairs off their highs. According to Yellen, the labor market “is quite tight, which causes pressure on wages.” Inflation has fallen but she also believes it is “premature to say the underlying inflation trend is below 2%” because the “risk to inflation is two-sided.” She said, “nothing suggests that the expansion will die anytime soon” and if she’s right, it would foster the Fed’s belief that the downtrend in inflation will be temporary. We’ve already seen producer prices edge up slightly in June after stagnating in May, but excluding food and energy, costs are still low. So at the end of the day, while we are still looking for a third hike, it won’t happen until the end of the year, which should limit gains in the dollar. Friday’s retail sales and consumer price reports could lift the greenback but we need a blowout number for USD/JPY to break 114. Slightly higher wage growth and producer prices point to stronger spending and inflation but with gas prices falling, the upside should be limited.
Thursday's best-performing currencies were the Australian and New Zealand dollars. The parabolic rise in the AUD/USD this week cannot be ignored. Data has been healthy with rising consumer inflation expectations joining the increases in consumer and business confidence. yet it was the sharp jump in Chinese imports that sent the Australian dollar to its strongest level in 3 months. The main resistance level to watch now is 0.7750, the year-to-date highs and Friday’s U.S. economic reports, which will determine whether or not AUD/USD breaches that level. The Reserve Bank won’t be happy to see the currency climb further since its last monetary policy meeting and the 3 Australian policymakers scheduled to speak next week (Heath, Debelle and Bullock) could use these opportunities to try to talk-down the currency.
NZD/USD, on the other hand, continues to reject 0.7350, a level that has held as resistance over the past 2 years. With consumer confidence falling in July, food prices growing at a slower pace and house sales plummeting, we can’t help but believe that further gains in NZD will be limited. The manufacturing PMI index was due Thursday and softer numbers could be just what is needed to reverse the New Zealand dollar’s course. The Canadian dollar, on the other hand, ended the day unchanged after slipping in the early part of North American trade. We still see further gains in CAD and the New Zealand dollar could be the best currency to buy it against after NZ economic reports.
Euro and sterling moved in completely different directions Thursday, leading to sharp losses in EUR/GBP. Dovish comments from ECB Rimsevics discouraged investors from buying euros. The ECB Governing Council member from the Bank of Latvia said QE will continue for a few years as inflation forecasts are still far the central bank’s goals. However according to the Wall Street Journal, Mario Draghi — scheduled to speak in Jackson Hole next month — could begin the discussion of reducing ECB's bond-buying program (taper). The Jackson Hole gathering is the first Fed meeting the ECB head has attended in 3 years and it comes at a time when many central banks are either in the process of or thinking about reducing stimulus. Recent improvements in the Eurozone economy should put Draghi in the same head-space as Poloz, Carney and Yellen, but the summit is still 6 weeks away. The real question is whether Draghi will start dropping hints about tapering at next week’s monetary policy meeting. Last month on June 27, he sent EUR/USD soaring to 9-month highs when he said “the threat of deflation is gone and reflationary forces are at play.” He also indicated that they may change policy from accommodative to unchanged. A day later the “ECB” said the market misjudged Draghi’s comments. So while Friday’s U.S. retail sales report will have the greatest near-term impact on EUR/USD, whether the pair breaks 1.15 on a sustainable basis depends on the ECB. Meanwhile, GBP/USD extended its gains on the back of hawkish comments from Bank of England member McCafferty who said he would be inclined to vote for a rate rise in August. And that was not a surprise considering that he dissented at the last meeting in favor of a rate hike.