By Kathy Lien, Managing Director of FX Strategy for BK Asset Management.
The U.S. dollar ended the week sharply higher after previous uncertainties never manifested. President Trump has yet to select his next Fed chair although Powell appears to be the most likely candidate. At the same time, the tensions between North Korea and the U.S. did not escalate. Does this mean that the risks have gone away? Certainly not. However the lack of fresh developments on either fronts coupled with the significant progress made on tax reform helped the U.S. dollar close out a strong week. The greenback experienced the strongest gains against the New Zealand dollar and Japanese yen but none of the major currencies escaped its rally. Looking ahead, investors will remain hopeful that the House will approve the budget reform plans and this positive thinking along with the sharp rise in U.S. yields on Friday could carry the dollar to fresh highs in the coming week.
Getting the budget bill passed would be the most meaningful progress for President Trump since taking office. It’s a crucial step to getting tax reform and provides the greatest opportunity for growth over the next few years. There’s no doubt that this news is significant enough to foster further gains in the greenback (as long as there’s no North Korea or Fed-chair shock). With no major U.S. economic reports on the calendar this past week, political headlines and Treasury yields dictated the dollar’s flows. USD caught a bid early in the week after Fed Chair Janet Yellen said her best guess is that soft inflation readings won’t persist. She was slated to speak after Friday's market close and based on the greenback's performance, investors expected continued hawkishness. Since her chance of being re-nominated as Fed Chair is slim, she may want to squeeze in one more hike before stepping down in February. According to the betting markets, Fed President Powell is the safe bet and from the perspective of continuity and his preference for gradual hikes, it may be the best choice for the stock market, next to Yellen. However Fed President Warsh and Stanford economist Taylor would be better for the dollar because they have been critical of the central bank’s easy monetary policies. Anyone outside of Powell, Yellen, Warsh and Taylor is a surprise that would not be looked at kindly by the market. This past week was devoid of any major market-moving U.S. economic releases and the coming week will be the same, so yields and political headlines will be the primary driver of dollar follows. According to the most recent economic reports, manufacturing activity is improving, jobless claims hit its lowest level in 4 decades (signaling payroll strength) and housing-market activity is mixed. Next week’s Markit PMIs, durable goods, new- and existing-home sales are not expected to show anything different. The most important number to watch will be Friday’s Q3 GDP report. Growth is expected to have slowed in the third quarter but the recovery in retail sales and trade activity puts the risk to the upside. There’s a good chance we’ll see 114 in USD/JPY.
The most important event risk on next week’s calendar will be the highly anticipated European Central Bank monetary policy announcement. EUR/USD has traded in a narrow range ahead of the announcement as investors wonder whether it will be a hawkish or dovish taper. Having mentioned the need to make changes to their QE program for months, Mario Draghi is widely expected to announce plans to reduce the amount of bonds they purchase next year. The only question is by how much and for how long? Most analysts expect the ECB to cut bond purchases by EUR20B to EUR40B a month until June of 2018. They could make a smaller reduction and shorten the time, but that’s unlikely. Or they could cut more and lengthen the period of purchases to September or December. Either way, investors care more about the amount of bonds bought per month than how long they will be doing it, so the main reaction will be to the numerical target. Last month, the ECB suggested that not all decisions will be made at this month’s meeting because the euro was a source of uncertainty. Still, the currency is now trading at 1.18 instead of 1.20 so they should not be as worried. Although there have been widespread improvements in the Eurozone economy since the last meeting, we believe that the central bank will opt for a dovish taper – cutting bond purchases by only 20B and extend it to September or beyond because they can always adjust it later and right now there’s too much political uncertainty. If we are right, the euro will fall. If we’re wrong and the ECB marries a more aggressive reduction with hawkish comments from Draghi, EUR/USD will hit 1.20 easily.
The Canadian dollar fell sharply on the back of Friday’s softer economic reports. Retail sales dropped -0.3%, when it was expected to rise by 0.5%. Excluding autos, demand was even weaker and in volume terms, sales dropped by the largest amount since March 2016. Consumer price growth accelerated but less than expected driving the year-over-year rate to 1.6% instead of 1.7%. These numbers confirm that the Bank of Canada will maintain a cautious bias at next week’s meeting and leave interest rates unchanged for the rest of the year. Like Mario Draghi, BoC Governor Poloz will be delivering a press conference after the rate decision. As no changes are expected, how the Canadian dollar reacts will be dictated by his degree of pessimism. Last month, Poloz said there is no predetermined path for interest rates and the BoC needs to proceed cautiously and can’t be mechanical. These comments sent the loonie tumbling as it led investors to believe the central bank is done tightening. There’s no reason for the BoC to adjust their tone at this time.
The Australian dollar spent the first part of the week trading lower against the greenback as the buck moved quietly upwards. However by the end of the week, it became a beneficiary of NZD outflows in a move that drove AUD/NZD to its strongest level in 17 months. The RBA minutes were relatively benign and the most important release – Australia’s September labor-market report – supported the end of week recovery. Australia added 19.8K jobs in September with steady growth seen in full- and part-time work. This improvement helped push the unemployment rate down to 5.5%, the lowest level in more than 3 years. Although the People’s Bank of China warned of excesses, Chinese industrial production and retail-sales growth accelerated slightly more than expected in September while GDP growth slowed by 0.1%. Looking ahead, Australian inflation data is scheduled for release and while important, we’re not sure how much impact it will have on AUD as the RBA maintains a firmly neutral policy stance.
Meanwhile, one of biggest stories this past week came from New Zealand. NZD extended its losses on Friday on the back on USD strength. With major policy differences between Labour and National, change is coming for the New Zealand economy. There will be major investments in the housing market with 100k affordable houses built and sold over the next 10 years, the RBNZ will add an employment mandate similar to the Fed, immigration will be cut back and the government will renegotiate elements of the Trans Pacific Partnership to increase restrictions on foreign home purchases. All of these steps are aimed at bolstering an economy that the new government sees as underperforming. For the RBNZ, an employment target could mean a longer period of easier policy. So while NZD/USD just experienced its largest one-day slide since August 24, 2015 – the day of the flash crash in U.S. equities – it’s a sell on rallies for an eventual move down to 68 cents. With only the trade balance on tap, NZD may spend the week with a political hangover.
Finally, while this past week’s U.K. economic reports failed to harden the case for BoE tightening, it didn't hurt it significantly. Investors may be pricing in a rate hike in November but based on the big drop in retail sales last month, they may delay the move to December. Inflation as measured by the consumer price report is on the rise but as some U.K. policymakers including Governor Carney pointed out this past month, CPI could have peaked in October. Thankfully, wages are rising, which should eventually translate into spending and higher prices. But it is not clear when that will happen. So even if the central bank proceeds with raising interest rates next month, their guidance is likely to be cautious. With no major economic reports on the calendar next week and no speeches scheduled for U.K. officials, Brexit headlines, the ECB meeting and the market’s appetite for U.S. dollars should determine how sterling trades. On a technical basis, GBP/USD has found support at the 50-day SMA, so if there’s a place for a reversal, it would be off those levels.