By Kathy Lien, Managing Director of FX Strategy for BK Asset Management.
Friday’s stronger-than-expected U.S. economic reports failed to inspire new gains for USD/JPY, but EUR/USD dropped to fresh 2-month lows. Americans are spending more and inflation is up, but the greenback was trading strongly ahead of Friday's reports -- so the rally fizzled after the data. It was still a good day for the dollar, especially versus the euro, British pound, Japanese yen and Swiss franc. Retail sales rose 0.6% in September, the strongest gain in 4 months. Excluding auto and gas purchases spending rose by 0.5% -- both reports were in line with expectations. Producer prices increased 0.3%, which was stronger than the market’s 0.2% forecast. Consumer sentiment pulled back in October according to University of Michigan after strong gains in September. The sentiment index dropped to its lowest level since September 2015 while the expectations component of the report dropped to the lowest since September 2014. Despite the uptick in retail sales, the drop in sentiment encouraged investors to take profits on long dollar positions ahead of the weekend. Also, the contribution to GDP growth will be less in Q3 than in Q2 because spending in July and August were weak. Fed Chair Janet Yellen spoke on Friday and didn’t say anything market moving. She indicated that maintaining accommodation too long could have its costs, which reaffirms her hawkish bias. This sentiment was shared by Fed President Rosengren, who said that the market’s expectations for a December rate hike sounds about right.
Looking ahead to the coming week, the U.S. dollar could take a back seat to more important, non-U.S. event risks on the calendar. They includes the European Central Bank monetary policy announcement, Bank of Canada Rate Decision, Australian and U.K. employment reports, RBA Minutes, China’s Q3 GDP number along with U.K. and Canadian retail sales. These are the most important releases on a long list of other market-moving events. From the U.S., the consumer price report, housing data, Empire State and Philadelphia Fed indexes are the main pieces of data on the U.S. calendar. CPI is an important input into Fed policy, but with inflation so low, it has become less market-moving than the jobs and spending reports. With that in mind, unless there is a huge one-way move in U.S. rates, we could see less consistency in the performance of the majors next week. We are still bullish U.S. dollars, but it will be important to watch Treasury yields -- if they fall, the dollar could experience losses, but if 10-year yields hit fresh 4-month highs, we can expect strong gains in the greenback.
Next week’s European Central Bank meeting will be the real test for euro, which dropped below 1.10 versus the U.S. dollar. Whether this level holds or gives, depends on ECB President Mario Draghi’s tone. We’ve seen a lot of conflicting headlines about the central bank’s thinking. Two weeks ago the big story was on tapering asset purchases and this week there was talk about extending / tweaking QE. Everything that we’ve heard from policymakers tells us they are comfortable with the current level of stimulus but stand ready and willing to increase -- it if the economy weakens. The last time the ECB met, President Draghi expressed more confidence about the outlook for the Eurozone economy, using the word "resilience" on numerous occasions. However they also lowered their growth forecasts and announced Eurosystem committees to further evaluate stimulus options. Interest rates will remain unchanged, but if Mario Draghi reinforces his concerns about the economy and puts greater emphasis on the need for more stimulus, further losses are likely. If he’s optimistic -- and we think he will be -- as there’s been significantly more improvement in the German and Eurozone economies since the last ECB meeting. The recent weakness of the euro goes a long way in boosting the economy and inflation, so positive comments could make 1.0950/1.10 a near-term bottom for EUR/USD.
Sterling will also be in focus next week courtesy of an exceptionally busy economic calendar. Not only will the British pound be responding to the outcome of the British High Court, which has a hearing on Parliamentary approval of Brexit, but retail sales, inflation and employment numbers are also scheduled for release. Previously, most U.K. economic reports have been strong, easing concerns about the impact of Brexit. We believe that next week’s economic reports will show continued improvements as the weakness of sterling boosts consumption and price pressures. The big story this past week was Prime Minister May’s concession to allow Parliament to vote on Brexit and Governor Mark Carney’s comments. Carney said he is not indifferent to GBP weakness but they could tolerate higher prices, which means there’s no urgency to intervene in the currency. Hearings before the British High Court began on Thursday and will continue until Monday. May argues that she has the sole right to determine when Article 50 is invoked but if the court finds that Parliamentary approval is needed, it would delay the process beyond the first quarter of 2017. This outcome could be enough to drive GBP/USD to 1.2450. It would also suggest that there would be a softer exit. However if the high court decides that it does not want to interfere with the Lisbon Treaty, then GBP/USD will reverse its gains quickly and aggressively. Either way, the decision will be appealed and sent to the Supreme Court, which may hear the case before year-end.
The Canadian dollar traded higher this week as oil prices hovered near 4-month highs. No major economic reports were released but continued pushback from OPEC nations along with a rise in oil inventories remains a problem for the loonie because once again there doesn’t seem to be much teeth to the OPEC deal. Next week the focus will return to Canada and its economy with a Bank of Canada rate decision on the calendar along with retail sales and consumer prices. The rate decision will set the tone for the CAD while the economic reports will likely validate the BoC’s bias as rates will remain unchanged. Outside of inflation, there’s been significantly more improvement than deterioration in Canada’s economy since their last meeting. CPI is a big problem but oil prices have been on the rise, which should alleviate some of those concerns.
The Australian and New Zealand dollars recovered from losses incurred at the start of the week. AUD/USD managed to turn positive, NZD/USD did not. Chinese trade numbers were terrible, so their rallies were driven primarily by U.S. dollar weakness although contrary to the Reserve Bank’s concerns, New Zealand data continued to surprise to the upside with manufacturing activity accelerating. In the coming week, New Zealand’s CPI report is due. Just this week, the RBNZ said inflation is low and monetary policy accommodative, but food prices are on the rise, so a soft CPI report is not a given. From Australia, we have the minutes from the last RBA meeting on tap along with the September employment report. Unlike the RBNZ, the RBA has been relatively optimistic about the economy and the labor data is likely to confirm that with the PMI reports showing stronger employment conditions in the manufacturing, service and construction sectors. Aside from these individual reports, Chinese Q3 GDP, retail sales and industrial production numbers will be released. Two of the big stories last week was China’s aggressive devaluation of its currency and its terrible trade numbers. The former is most likely in reaction to the latter. Both developments are negative for Australia and New Zealand who count on Chinese demand. The only reason why AUD and NZD are not trading lower is because of carry-trade demand.