By Kathy Lien, Managing Director of FX Strategy for BK Asset Management.
What was supposed to be a strong week for the U.S. dollar turned into a crushing one for the greenback. Fed Chair Janet Yellen did not solidify her positive views, providing the dollar with the catalyst it needed to hit new highs. Instead, she expressed concerns about low inflation, which was confirmed by the last consumer price report, which stagnated in June, causing the year-over-year CPI rate to drop to its lowest level in 8 months. Soft price growth wouldn’t be such a problem if retail sales had increased. But instead of rising, spending contracted for the second month in a row by -0.2% in June. There was no support from auto and gas purchases, which also softened last month. So between the surprisingly weak U.S. economic reports and Yellen’s unimpressive performance on Capitol Hill, the U.S. dollar traded lower against all of the major currencies this week. On the first day of her testimony, Yellen sent the dollar tumbling lower when she said inflation is running below their goal after recent declines. On the second day of her testimony the greenback recovered its losses after Yellen recognized the improvements in the labor market saying that while inflation has fallen, it is “premature to say the underlying inflation trend is below 2%” because the “risk to inflation is two sided.” She also said, “nothing suggests that the expansion will die anytime soon.” Unfortunately with retail sales and CPI falling, no one seems to believe her. A September rate hike is completely off the table and investors will remain skeptical about December. Until data starts to improve consistently, investors will be reluctant to buy dollars, especially in light of new opportunities presented by central banks who have just started to turn hawkish. So even if the Fed is one of only 2 central banks raising interest rates, fresh guidance from other countries could create renewed demand for those currencies at the expense of the U.S. dollar.
The next big focus for the forex market will be the European Central Bank’s monetary policy meeting. After rising to a 1-year high of 1.1490, EUR/USD struggled to extend its gains above 1.15. Investors worry that Mario Draghi will disappoint as did Janet Yellen. Draghi’s comments last month took euro to a 1-year high versus the U.S. dollar and now everyone will be tuning into the ECB press conference to see whether his hawkishness is repeated or downplayed. In June, Draghi caught the market by surprise when he said, “the threat of deflation is gone and reflationary forces are at play,” indicating that they could change their policy stance from accommodative to unchanged. However a day later, the “ECB” said the market misjudged Draghi’s comments and on Thursday ECB member Rimsevics said QE will continue for a few years as inflation forecasts are still far from the central bank’s goals. To confuse things further, the Wall Street Journal said Draghi will talk about reducing ECB's bond-buying program at the Jackson Hole summit next month. These conflicting comments will discourage investors from taking on large positions ahead of the rate decision.
We believe that the European Central Bank has already set the course for its next policy change. It's no secret that it prefers to prepare the market for major changes and that is exactly what it is doing now. The ECB is getting ready to taper, or reduce bond buying, and Draghi will most likely use next week’s meeting as a platform to reinforce those plans. Eurozone data has been healthy with retail sales, manufacturing- and service-sector activity improving across the region. Inflation is a bit of a problem but stronger economic activity should naturally lead to higher prices. The only problem is the currency, which is up 8.5% year to date and the appreciation over the past month hurts inflation and export activity. With that in mind, we expect EUR/USD to test and possibly break 1.15 on Draghi’s optimism.
The commodity currencies had a very strong week and while those gains could continue for some currencies, it may not for others. The best performer was the Canadian dollar, which raced to a 14-month high versus the greenback. For the first time in 7 years, the Bank of Canada raised interest rates by 25bp and upgraded its 2017 and 2018 GDP forecasts. BoC effectively became the second major G7 central bank to tighten, giving investors no reason to believe that it will stop. The BoC attributed the slowdown In inflation to temporary factors and Governor Poloz said there is “no doubt interest rates will be higher over time.” With the recent improvements in data, the “economy no longer needs as much stimulus” and the upward revisions in GDP showed the output gap closing sooner than they previously anticipated, according to Deputy Governor Wilkins. Poloz now sees inflation returning to BoC's target level within a year. This past week’s Canadian economic data including housing data confirmed the BoC’s positive stance and the upcoming retail sales and consumer price reports are expected to do the same. USD/CAD is on track to hit 1.25 and it may not be long before this target is reached.
We’ve also seen a parabolic rise in the Australian dollar. Data has been healthy with rising consumer inflation expectations joining the increases in consumer and business confidence but it was the sharp jump in Chinese imports along with a widening AU-US yield spread that sent the Australian dollar to its strongest level in a year. Unfortunately, the Reserve Bank won’t be happy to see the currency climb further since its last monetary policy meeting and the 3 Australian policymakers scheduled to speak next week (Heath, Debelle and Bullock) could use these opportunities to try to talk down the currency. The RBA minutes are scheduled for release along with Australia’s employment report. When the RBA last met, it sent AUD tumbling lower as it refrained from expressing the same hawkish sentiment as some of its peers. If the RBA minutes are cautious, AUD/USD will peak. Australia’s employment report is not expected to help AUD as slower job growth in the manufacturing and construction sectors offset stronger growth in the service sector.
The New Zealand dollar on the other hand only gained strength in lockstep with AUD. With consumer confidence falling in July, the business PMI index dipping, food prices growing at a slower pace and house sales plummeting, further gains in NZD should be limited. Next week’s second-quarter CPI report is the most significant piece of data on New Zealand’s calendar but at the start of the week, the most impactful reports for AUD and NZD will come from China. Second-quarter GDP numbers are scheduled for release along with Chinese retail sales and industrial production numbers. GDP growth is expected to accelerate on a quarterly basis and slow year over year.
Last but certainty not least, investors are watching sterling to see how far GBP/USD rises. Having taken out 1.30 and then the year-to-date high of 1.3050, GBP/USD climbed to an 8-month of 1.3114. The currency pair has performed very well over the past week thanks to the consistent hawkishness of U.K. policymakers. Investors quickly forgot about monetary-policy committee member Broadbent’s cautious comments and focused purely on McCafferty’s plan to vote for a rate rise in August. Yet this is not surprising considering he was one of the 3 members of the MPC who voted in favor of immediate tightening at their last meeting. So while Brexit talks continue to move slowly, as long as data validates the BoE’s optimism and policymakers continue to talk up the need to remove policy accommodation, GBP will rise. That’s a big 'If,' however, because like the U.S., U.K. data has not been uniformly positive, which makes next week’s retail sales and inflation reports so important. The smaller decline in shop prices and the uptick in BRC retail sales monitor points to stronger numbers that should help rather than hurt the GBP/USD rally.