By Kathy Lien, Managing Director of FX Strategy for BK Asset Management.
Expectations for monetary policy will drive currencies this week but investors will be less focused on the Federal Reserve and more focused on what other central banks are doing. More specifically, investors are selling euros ahead of Thursday’s European Central Bank meeting on the fear that Mario Draghi could say or do something that would be consistent with easier monetary policy. September was a tough month for the Eurozone’s largest economy with industrial production and factory orders falling. This caused manufacturing- and service-sector activity to slow, adding pressure on the ECB to ease. Inflation also remains extremely low and as ECB member Nowotny pointed out last week, “inflation targets are clearly being missed.” If the outlook was bright, the ECB could be less concerned but between declining orders, weaker demand from China and a stronger euro, Germany and the region’s overall economy could slow further in the fourth quarter and for these reasons, the ECB needs to seriously consider increasing stimulus.
There are 4 ways that the ECB could crush EUR/USD this week. The most damaging scenario for the euro would be if the central bank cuts interest rates. However considering that interest rates are already -20bp, the chance of the ECB driving rates even lower is low but the benefit is that it would broaden the type of assets the central bank could buy and require less logistical hurdles than more QE. The second option for the ECB would be to increase the size of its QE program. If they choose to do so without extending the end date, it would represent a more aggressive frontloaded operation that would also be extremely bearish for the euro. The third option would be to expand the types of bonds they can purchase to bank and corporate bonds. The final most talked about possibility is a simple extension of the soft deadline for the current program beyond September 2016. Given recent comments from Draghi and Weidmann, there’s not enough consensus for a change in policy this month but we anticipate more dovishness from the central bank President when he speaks on Thursday. The greatest risk is the ECB press conference, but going into the monetary policy meeting we have strong reasons to believe that euro will trade lower against the U.S. dollar.
The lack of market-moving U.S. data this week could actually be beneficial to the U.S. dollar as it allows investors to hone in on the prospect of more stimulus abroad. The greenback traded higher against all of the major currencies Monday with the exception of the British pound, even though U.S. stocks and rates moved slightly lower. Housing starts and building permits are scheduled for release on Tuesday and for the most part, the real estate market is expected to remain stable and pose no major threat to the outlook for the U.S. economy.
Monday's best-performing currency pair was USD/CAD, which surged above 1.30 on the back of political uncertainty and lower oil prices. As we went to press, we were waiting to learn if Prime Minster Harper’s government retained power or was ousted by Liberal rival Trudeau. Based on the how close the polls were, the people want change. But the markets hate political uncertainty and the Canadian dollar will fall on a Harper loss. We have the results by 10pm ET when polls in British Columbia close. Meanwhile, $50 is proving to be rock solid resistance for oil. Prices fell 2.9% Monday, backing off this key level following reports of slower Chinese growth and a potential nuclear deal with Iran. GDP growth in China slowed to 6.9% in the third quarter. While that was the weakest pace of growth since 2009, it was better than expected, limiting losses for AUD and NZD. Retail sales in China also ticked up but industrial production eased to 5.7%, its lowest level since April 2015. Part of NZD’s resilience can also be attributed to stronger service sector activity – the PMI index rose to 59.3 from 58.5.
The RBA minutes were scheduled for release Monday evening. The Australian dollar rose strongly after the last Reserve Bank meeting. While the central bank left interest rates unchanged and provided no guidance on a future move, Glenn Stevens' comments that “equity market volatility has continued, but the functioning of financial markets generally, has not to date been impaired” and that “regulatory measures are helping to contain” housing market risks suggests that they are in no rush to ease again. However Westpac’s decision to raise mortgage rates by 20bp could prompt a reaction from the central bank, which may want to take steps to offset the tightening caused by this move. We are not going to hear any of that in the latest RBA minutes but it is something to consider going into next month’s meeting.
The only currency that outperformed the dollar was sterling. GBP/USD is itching to break 1.55 but with the 100-day SMA capping gains, it needs a catalyst -- otherwise it will give up part of last week’s strong gains. The main U.K. event risk this week is retail sales and after the British Retail Consortium’s strong sales report, we believe that consumer spending recovered further in September and if we are right, it will be significant enough to drive GBP/USD firmly above 1.55.