By Kathy Lien, Managing Director of FX Strategy for BK Asset Management.
The U.S. dollar started the week firmer against many currencies including the euro, Japanese yen and New Zealand dollar. After selling off hard last week, the greenback found support from higher yields and stronger PMI numbers from Markit Economics. Despite the drop in manufacturing activity in the NY and Philadelphia regions, Markit Economics saw an uptick in manufacturing- and service-sector activity in July. Although we won’t get the ISM reports until next month, these numbers gave investors hope ahead of FOMC.
The general trajectory of Fed policy is on everyone’s minds and few will argue that the most recent rate hike won’t be its last even though Fed Fund futures show investors pricing in less than 50% chance of another rate hike before the end of the year. For the past few weeks, we’ve seen more negative data disappointments than positive surprises and that dealt a strong blow to the confidence of dollar bulls. With no major economic reports scheduled for release before Wednesday’s FOMC rate decision, investors could approach this week’s meeting with the same skepticism. There’s no question that the Fed will maintain a positive outlook and a hawkish bias but the real uncertainty is whether the market believes them. As no hike is expected in September, December is a long time from now so investors will still be in 'show-me' mode – waiting for data to confirm the Fed’s hawkish views before leveraging into long dollar trades. So even if a hawkish FOMC statement highlighting the ongoing improvements in the economy ends up driving the dollar higher, we believe it will remain under pressure ahead of next month’s nonfarm payrolls report. Tuesday’s U.S. economic reports aren’t expected to lend much support to the greenback as consumer confidence and Richmond Fed manufacturing could surprise to the downside. Aside from the FOMC meeting, Q2 GDP is also scheduled for release and it is the beginning of earnings season. Politics are worth watching as well with the Senate possibly voting Tuesday on whether they should open debate on a health-care bill.
Meanwhile, the EUR/USD rally came to a halt on the back of softer Eurozone data and the recovery in the greenback. Manufacturing activity in the Eurozone slowed in July, causing the PMI composite index to drop to 55.8 from 56.3. Service-sector activity remained steady but that was not due to strength in the region’s 2 largest economies (France and Germany). Germany experienced slower growth all around and while service-sector activity in France slowed, manufacturing accelerated. These are the first signs of the strains caused by a strong currency. With the PMIs falling short of expectations and investor confidence weakening (ZEW), we believe Tuesday’s German IFO report will add further pressure on the euro. Businesses are the most sensitive to the exchange rate and the prospect of higher interest rates. But having fallen to a low of 1.1625 intraday, EUR/USD never revisited that level during the NY trading session, which is a testament to its strength. Unfortunately, we believe new lows will be reached on Tuesday if IFO surprises to the downside, at which point we’ll be looking at 1.1550 for support.
Sterling, on the other hand, was one of the day’s strongest performers, which is interesting given the lack of news flow. GBP/USD found its way back above 1.30 right around the same time as the Eurozone PMI reports were released, which tells us that the move was driven largely by profit taking on long EUR/GBP positions. UK rates also ticked up slightly, lending support to the currency. The most important release for the U.K. this week will be Q2 GDP. The recent recovery in spending should contribute positively to growth.
We’ve been looking for USD/CAD to hit 1.25 for some time now and it finally breached that level on Monday, hitting a fresh 14-month low in the process. The latest move was driven by stronger wholesale sales and the more than 1% increase in oil prices. While the pair ended the NY trading session above the key 1.25 level, the 2016 low of 1.2461 is more significant support and we would not be surprised if USD/CAD drifted to that level before Friday’s Canadian GDP report. The Australian dollar also traded higher than the greenback but ended closer to its lows. The consolidative price activity below 80 cents highlights the significance of this key level. While some specs may want to run 0.80, there’s heavy defense of option barriers at this key level. The New Zealand dollar, on the other hand, bucked the trend and weakened against the U.S. dollar. It was the day’s worst performer and with no data to explain the move, the softness of past reports could finally be catching up to the currency.