By Kathy Lien, Managing Director of FX Strategy for BK Asset Management.
Friday’s U.S. GDP report sealed the dollar’s fate with weaker-than-expected growth sending the currency tumbling. The greenback ended the week lower against every major currency except for the Swiss franc. The U.S. economy expanded by only 2.6% in the second quarter slightly less than the 2.7% consensus forecast. While this is a significant acceleration from last quarter’s levels investors honed in on the downward revision to Q1 growth, the headline miss and the dramatic slowdown in price growth. Even the uptick in personal consumption or the positive revision to the July University of Michigan consumer sentiment index failed to help the greenback. We’re looking at another busy week ahead but first:
The dollar was set on a downward course this week by the Federal Reserve’s monetary-policy announcement. Although the Fed did exactly what the market anticipated, that wasn't enough. They left interest rates unchanged, acknowledged that inflation declined and set the stage for reducing asset purchases in September by saying balance-sheet normalization will begin “relatively soon.” These tweaks were all anticipated but somehow investors wanted more. The problem is that everyone is growing skeptical of another rate hike by the central bank this year as Fed Fund futures show only a 40.8% chance of tightening by December. Consumer demand, inflation and wage growth are weak and if Friday’s nonfarm payrolls report does not impress, all hope could be lost for the U.S. dollar. Despite mixed data, Federal Reserve officials have been pounding the table about the need for additional policy normalization and while the market wants to believe them, it needs one piece of unambiguously positive data. With how much the greenback has been sold, traders won’t be looking for much — nonfarm-payroll growth is expected to rise by only 180K versus 222K in June. As long as job growth exceeds 170K AND wage growth rises 0.3% or more — AND the unemployment rate drops from 4.4% to 4.3% — the dollar will soar. However if wage growth grows by 0.2% or less and the unemployment rate holds steady, even another 200K increase in payrolls may not be enough to save the dollar. Aside from NFPs, ADP, pending home sales, manufacturing and non-manufacturing ISM numbers are scheduled for release — all of which will be used to shape the market’s expectations for the jobs report.
The Australian, New Zealand and Canadian dollars climbed to multi-year highs this past week but the rejection of 80 cents for AUD/USD and NZD/USD’s struggle near 75 cents screams 'top'. Whether that happens or not should hinge on upcoming economic reports and a rate decision. Still, we’ve seen how AUD and NZD can defy fundamentals in favor of carry. For example, it wasn’t until the U.S. dollar rebounded on Thursday that AUD/USD and NZD/USD finally peaked. Weaker consumer-price growth in Australia and cautious comments from Reserve Bank Governor Lowe failed to hurt Aussie. The same is true of a herd disease in New Zealand and the previous trend of softer data. AUD and NZD climbed to 2-year highs despite these negative developments. However the Reserve Bank could have tougher words for the market when it meets next week. We know that RBA Governor Lowe is worried about wage growth and the strong currency so there’s absolutely no reason to expect that it will say anything to suggest that a rate hike is on the table. Just this past week he said Australia doesn’t “need to move in lockstep with global peers” because it hasn't eased as much. With that in mind, the labor market is very strong, business confidence and activity is up thanks in part to the increase in Chinese demand last month. If the RBA emphasizes the negative impact of the strong currency and low inflation, AUD/USD could extend its losses below 79 cents. However in an environment of a falling USD and rising AUD, if they keep their statement virtually unchanged, the preservation of yield could be enough to lift the Australian dollar. Aside from the RBA rate decision, manufacturing- and service-sector PMI numbers are scheduled for release along with retail sales, the trade balance and Chinese PMIs. For the New Zealand dollar, another dairy auction and second-quarter employment report top the calendar. We are looking for relatively subdued numbers that should weigh on the currency but the New Zealand dollar will also be affected by yield and risk appetite. The labor market is expected to have suffered from the recent weakness in business activity and decline in dairy prices with the risk validated by a gradual slowdown in the Manpower employment.
After 4 weeks of persistent strength, the Canadian dollar continued to extend its gains against the U.S. dollar. On Thursday it seemed as if a bottom could be in place but stronger-than-expected GDP growth in May renewed the uptrend. The economy expanded by 0.6%, 3 times more than expected. This acceleration drove the year-over-year rate from 3.3% to 4.6%, the strongest in almost 17 years. So while it may be tempting to pick a bottom in USD/CAD, this pace of growth indicates that there is room to raise interest rates. Earlier in the week, there were reports that Prime Minister Trudeau is unhappy about the central bank’s latest rate hike. Whether true or not, the uptrend in oil prices and Canadian fundamentals justifies the central bank’s decision. However for an export-dependent nation like Canada, the 10% rise in the currency over the past 2 months will eventually catch up to the economy and in turn, the loonie. At some point the data improvements will turn into data disappointments and that could start with next week’s Canadian employment report as a slowdown in the labor market is expected after 2 very strong months of job growth.
Sterling will be next week's big focus with July PMIs (Manufacturing, Construction, Services), the Bank of England’s monetary policy announcement and Quarterly Inflation Report scheduled for release. The BoE meeting will be particularly important as data has been at odds with the central bank’s guidance. When it last met in June, the market was surprised that 3 members voted for an immediate rate hike. At the time, their hawkishness came in the face of softer data, but rising inflation created a deep divide within the central bank. MPC members Forbes, Saunders and McCafferty voted for a hike and in the weeks that followed, it appears that Haldane and Carney share their hawkish views and if all 5 vote for a hike, it would be a majority. Of course that is unlikely as the central bank as a whole has not prepared the market for an August hike. But it often likes to telegraph major changes in its Quarterly Inflation, which could could be next week's big announcement. If the BoE statement/Quarterly report is hawkish and/or one more member votes in favor of tightening, GBP/USD will hit fresh 2-year highs above 1.32. Based on the central-bank guidance, we have every reason to believe it will prepare the market for policy normalization though data is not on its side. We’ll have to see how the PMI reports fare (manufacturing and services are due before the rate decision) but retail sales, consumer confidence, wage growth and inflation weakened since the last monetary policy meeting.
With all of these big events on the calendar, the euro could end up taking a backseat. While the latest Eurozone economic reports were mixed (PMIs were down but German IFO increased), the currency is supported by the European Central Bank’s hawkishness. In the coming week, Eurozone inflation, GDP and retail sales numbers are scheduled for release. Traders will be looking for them to validate the ECB’s views but the reports will be less market-moving than many of the other pieces of data and event risks on next week’s calendar. The most important thing to keep in mind is that the market is bullish euros, so if the RBA disappoints or NZ data is soft, we could see strong gains in EUR/AUD and EUR/NZD. EUR/GBP will be driven by the BoE and UK PMIs, while the EUR/USD is likely to remain firm ahead of the U.S. nonfarm payrolls report — unless there’s a major upside surprise in ADP or non-manufacturing ISM.