By Kathy Lien, Managing Director of FX Strategy for BK Asset Management.
Concerns for low inflation are limited. While European Central Bank head Mario Draghi said Thursday that measures of underlying inflation remain low, he also indicated that core inflation will rise over the medium term as stimulus pass-through supports demand and favorable financing conditions help investment. Their survey results show a solid, broad-based recovery that allows investors to look past the central bank’s warning that it could boost the size and duration of QE if needed. The ECB is encouraged by the performance of the economy, though not particularly concerned about the rise in the currency, as it plans to make a decision about QE in Autumn. Although Draghi said tapering scenarios were not discussed at this meeting and they didn’t talk about what will happen in September, the ECB’s tease about discussing tweaking stimulus sometime between September and November was enough to satisfy euro bulls. EUR/USD climbed to its strongest level in 23 months and it should only be a matter of time before it breaks the 2-year high of 1.1714. A move to 1.18 is inevitable as long as ECB officials don’t jawbone the currency, though 1.20 would require strong PMIs.
The U.S. dollar may have taken a backseat to all of Thursday’s actions, but the downtrend remains strong as USD/JPY traded lower for the third consecutive day. The Philadelphia Fed Manufacturing Index fell to an 8-month low in July, reinforcing the market’s concern about the U.S. recovery. Jobless claims declined but they have been low for some time. With all of these recent disappointments, many investors will be skeptical going into next week’s Federal Reserve meeting. Like the ECB, the Bank of Japan left interest rates unchanged. Although it upgraded its economic assessment and raised its GDP forecast, BoJ lowered this fiscal year’s inflation forecast to 1.1% from 1.4%. The bank also delayed the timing for reaching its 2% inflation target to around fiscal 2019 from around fiscal 2018. Which means the BoJ will continue its accommodative policy for the foreseeable future with no talk of exit.
Meanwhile, sterling extended its losses for the fourth consecutive trading day, rejecting 1.30 in the process. Stronger-than-expected retail sales failed to convince investors that Bank of England Governor Carney is serious about raising interest rates. After falling in May, spending recovered in June with retail sales rising 0.6%. Not only was that greater than the 0.4% forecast, but it was validated by a 0.9% increase in core retail sales, which excludes auto fuel. While it should have stemmed sterling's slide, investors worry that UK investors are spending beyond their means based on the slowing earnings growth. More importantly, although spending rose more than expected, the increase failed to offset the past month’s decline and when combined with stagnant price pressures, the case for a rate hike in the fall is weak. The market is not happy that Prime Minister May will remain in office as she is now seen as a weak leader with a Brexit strategy that is in shambles. The EU is still pushing for a divorce payment and chances are the U.K. will acquiesce one way or another. GBP/USD has support at 1.2875 but the latest decline could take the pair as low as 1.2750.
The commodity currencies continued to charge higher with the New Zealand dollar leading the gains. NZD rose to its strongest level in nearly 2 years as stops were taken out above the February high of 0.7275. Thursday’s move represents a dramatic reversal for both the Australian and New Zealand dollars, which sold off hard after Australia’s employment report. Although Australia created 62K full-time jobs, the second-strongest one-month increase in full-time work since June 2011, AUD/USD failed to hold onto its initial gains. The currency pair came within 10 pips of 80 cents before U-turning in a move that took it below 79 cents. Which was purely profit taking underneath a key technical level because the rise in full-time employment and the increase in the participation rate bodes well for consumption and growth. Even though AUD/USD is up 10% year to date, the consistent improvement in the labor market, increase in business confidence, rise in inflation expectations and stronger growth in China should make the central bank less worried about the level of the currency. The Canadian dollar is in play Friday with consumer prices and retail sales scheduled for release. We believe both reports will be strong, validating the central bank’s rate hike and putting USD/CAD on tract to test 1.25.