Yellen, Tax Reform And Draghi Rock The Markets

By Kathy Lien, Managing Director of FX Strategy for BK Asset Management.

Between Fed-chair talk and the European Central Bank’s monetary policy announcement, it was an incredibly lively day in the foreign-exchange market, particularly when the ECB announced its QE change minutes before Politico reported that Yellen and Warsh are out of the Fed-chair race. Although the White House reported that no decision has been made on the next Fed chair, Politico’s report reinforced the market’s suspicion that Powell and Taylor are Trump’s final 2. Powell is less positive for the dollar than Taylor but a Fed chair-vice-chair combination, which is very, likely would encourage further gains in the greenback. But until the selection is confirmed, investors are leary of being too optimistic. What’s unambiguously dollar positive is the news that the House passed a budget resolution that clears the path for tax reform and will allow a key tax bill to pass Congress without Democratic support. The close decision was crucial to advancing President Trump’s tax agenda and paves the way for the House to unveil their tax plan next Wednesday. We believe that the dollar will hold onto its gains ahead of the November 1 announcement. It could also be helped by Friday’s third-quarter GDP report. Even though economists are looking for slower growth, strong spending and trade activity between the months of July and September favors an upside surprise.

The euro, on the other hand, crashed on the back of the European Central Bank’s monetary policy announcement. The ECB cut its asset-purchase program by 30 billion euros starting in January and will continue buying bonds at this pace until September 2018. While this was exactly what most economists anticipate, it was slightly less than what some euro bulls may have hoped for. More importantly, the ECB said it will keep rates at current levels well past the end of QE. That means the first rate hike will not be until October 2018. Nothing else mattered after Draghi made it clear that rates won’t be increased any time soon. The market completely ignored his positive comments on growth, the small increase in wages and ECB's view that core inflation will rise gradually in the medium term. EUR/USD broke below 1.1700 and appears poised to test the next round number (1.1600) below. Spain’s political troubles aren’t helping. Catalonia’s leader called off early elections. He’s running out of options in the face of heavy handed tactics by the central government. The next big focus will be Catalan parliament meeting before the end of the week, where perhaps we’ll see more clarity.

Sterling followed the euro lower, erasing most of Wednesday’s gains. According to the Confederation of British Industry, retail sales tumbled in October. The CBI index dropped from 42 to -36 to its lowest level since March 2009. Only 15% of retailers reported higher sales volume from a year ago while 50% said volume was down. The CBI index tends to have a very strong correlation with the broader retail sales report so today’s release suggests that spending may have fallen further in the month of October after dropping -0.7% in September. Apparently car production also weakened with output dropping 4.1%. Despite today’s sell-off GBP/USD has significant support above 1.31.

All 3 of the commodity currencies traded lower against the greenback today with NZD leading the slide following another soft trade balance report. Instead of improving, the trade deficit barely improved in September with the deficit at -1143M vs. -1179M the previous month. Although we saw upticks in both exports and imports, the rise in the U.S. dollar and the policies of the new government continue to weigh on the currency. USD/CAD, on the other hand, extended its post-BoC gains with the pair now eyeing the 50% Fibonacci retracement of the May-to-September slide, near 1.2925. AUD/USD broke below the 200-day SMA ahead of Thursday's producer price report. Inflation increased in the third quarter and while the PPI report is likely to confirm the rise, it is unlikely to provide much support to the currency after disappointing CPI reports earlier this week. The RBA still has no plans to raise interest rates and this steady policy should keep AUD under pressure. As the commodity currencies are driven by U.S. dollar strength, the next stop for AUD/USD should be the 50-week SMA, near .7630.