BoE Makes Big Play But Is That All? Plus, NFP Outlook

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

Thursday's big story was the British pound and the Bank of England’s decision to combine a 25bp rate cut with a 60 billion government bond-buying program and a new initiative to buy 10 billion pounds of corporate bonds. This multi-step approach sent a strong message to the market and drove sterling sharply lower against all of the major currencies. The Bank of England over-delivered because it felt that “by acting early and comprehensively, the MPC can reduce uncertainty, bolster confidence, blunt the slowdown, and support the necessary adjustments in the U.K. economy”, according to Mark Carney. The central bank felt that the outlook for growth had “weakened materially” since Britain’s decision to leave the European Union but BoE's GDP forecasts show most of the pain coming in 2017 -- not 2016. In fact, the BoE left its 2016 growth forecasts unchanged in it Quarterly Report and slashed its 2017 forecast from 2.3% to 0.8%. Its inflation forecasts were increased due to the weakness of the pound with the central bank now looking for their 2% price target to be reached in Q4 of 2017 compared to Q2 of 2018. BoE also expects the unemployment rate to rise to 5.4% in Q3 2016 compared to a previous forecast of 4.9%.

Generally speaking, the Bank of England’s outlook is grim, which is part of the reason why it felt the need to do more than what the market discounted. However the tone of Governor Carney’s comments was not overwhelmingly dovish. Yes, the central bank is ready to lower the bank rate further if needed and increase all elements of Thursday’s package, but Carney also made it very clear that the “lower bound in interest rates is above zero” and that he is “not a fan of negative interest rates”. He believes that helicopter money is a “flight of fancy” and he doesn’t see a scenario where negative rates is discussed. So if it were to ease again, it would be in other ways, most likely through additional bond purchases. This explains why we didn’t see much additional follow through in GBP/USD after the initial drop in sterling. The Bank of England will want to wait and see how its latest measures impact the economy before taking additional action, which that may not be until early next year. For the time being, we see the BoE in wait-and-see mode and that steady stance could lead to a bounce in the currency.

With that in mind, we still believe that the British pound will fall but the greatest weakness will be against other currencies and not necessarily the U.S. dollar. We saw that Thursday with GBP/CAD, GBP/NZD and GBP/AUD falling nearly 2%. Given the extent of short sterling positions, we do not rule out a squeeze to 1.3200 before another move lower, but it appears to be only a matter of time before 1.3100 is broken.

The focus now shifts to the U.S. dollar. Nonfarm payrolls are scheduled for release Friday and ahead of this key event there was very little consistency in USD's performance. The greenback traded lower against JPY, AUD, NZD and CAD but moved higher versus EUR, GBP and CHF. After the strong increase in June, there’s no doubt that job growth slowed in July and the big question is by how much. Economists are currently calling for job growth around 180K and any reading greater than 200K will be positive for the dollar as long as the unemployment rate improves and average hourly earnings rise as expected. Any miss in the headline or underlying components will send the dollar tumbling lower.

While the leading indicators for nonfarm payrolls point to a decline, the number may not be that bad. The 4-week moving average of jobless claims declined, continuing claims are lower, Challenger Grey and Christmas reported a sharp drop in job cuts and corporate payrolls increased slightly according to ADP. Although the employment component of non-manufacturing and manufacturing ISM declined, the dip was small and consistent with the drop in payrolls already forecasted. Consumer confidence is also down marginally according to the Conference Board’s survey, leaving the only major deterioration reported by the University of Michigan. There’s no doubt that the U.S. economy is outperforming its peers, which should make U.S. assets and the U.S. dollar more attractive in comparison. For these reasons and the fact that Japan’s big event risks are over, we anticipate a stronger recovery in USD/JPY.

Arguments For Stronger Payrolls

1. 4-week average jobless claims declined
2. Continuing claims lower as well
3. Sharp drop in job cuts reported by Challenger
4. ADP employment change ticked up slightly

Arguments Against Stronger Payrolls

1. Employment component of non-manufacturing ISM dips slightly
2. Employment component Manufacturing ISM dips slightly
3. Consumer Confidence Index drops slightly
4. University of Michigan Sentiment Index falls sharply

After breaking below the 50-day SMA on Wednesday, EUR/USD extended its losses. There were no major economic reports released from the Eurozone but U.S dollar strength dictated the currency pair’s performance. The decline would have probably been steeper if not for the strong demand for EUR/GBP. We continue to look for EUR/USD to test its 200-day SMA at 1.1080.

Meanwhile all 3 of the commodity currencies traded higher Thursday. The Canadian dollar is in play Friday with CAD employment, trade and IVEY PMI scheduled for release. The recent decline in USD/CAD has taken the pair to 1.30, a key level ahead of Friday's data. Oil is in an uptrend but if Friday’s economic reports surprise to the downside, we could see a pop in USD/CAD. The rise in commodity currencies was driven entirely by U.S. dollar strength as data from Australia was underwhelming. Retail sales rose 0.1% compared to 0.3% forecast. Despite the disappointment, AUD/USD still traded above 76 cents. The New Zealand dollar, on the other hand, is stuck in a 0.7125 and 0.7250 range. NZD found selling pressure after touching the 0.72 level. The range is likely to continue into next week as RBNZ comes into focus. Australia and New Zealand have no releases coming up.