By Kathy Lien, Managing Director of FX Strategy for BK Asset Management.
For the past two weeks investors have been scratching their heads over USD's underperformance. Data has been good, the U.S. economy is improving and practically every Federal Reserve official who had an opportunity to speak said rate hikes are coming. So why has the U.S. dollar struggled to rally, particularly against the Japanese yen? The answer lies in expectations -- the media has been talking up the possibility of a March rate hike and investors are just not convinced that it will happen so quickly. The Federal Reserve telegraphed plans to raise interest rates 3 times this year and many believe that these moves will be made at the quarterly meetings coinciding with Yellen’s press conference. The media has circled around these dates (the next one is in March) and rightfully so as the presser will give Yellen the opportunity to explain the central bank’s decision.
However Fed Fund futures show the market only pricing in a 36% chance of a Fed hike next month and a 63% chance of a move in May. Which means there’s a misalignment between what the data is showing, what the Fed has been saying and what the market believes. We think the dollar should be trading higher but there’s no question that investors need more convincing. This could come in the form of an aggressive tax-cut plan from Trump that provides the fiscal stimulus everyone is waiting for, a hot nonfarm payrolls report and/or clearer guidance from the Fed leadership. While nonfarm payrolls won’t be released next week, President Trump delivers a speech before a joint session of Congress on Tuesday when he is expected to unveil his “phenomenal tax-cut plan,” which will be followed by speeches from Yellen and Fischer on Friday. In between, we’ll hear from more U.S. policymakers, get a glimpse of the Beige Book and see how the U.S. economy has been performing. Manufacturing and non-manufacturing ISM reports are scheduled for release along with consumer confidence, personal income and personal spending. While these economic reports are important, Trump’s speech and policy plans will dictate how USD/JPY trades in the coming week. The currency came under heavy selling pressure in previous days and looks vulnerable to a deeper correction.
The euro ended the week lower against the greenback. Politics will remain front and center for the euro as investors watch for fresh French election headlines. Two candidates (Bayou and Jadot) pulled out this past week and more could follow. Any decrease in the chance of Marine Le Pen becoming the next French President would be viewed as negative for the currency. Recent polls show Le Pen in the lead -- even in a race with scandal-laden Filion not far behind. Le Pen’s popularity rose after riots over an alleged police rape spread across the suburbs of France. Her anti-government/terrorism/immigration/EU views are gaining traction but major news agencies are describing a victory by this far-right candidate as the next major political earthquake. It would usher a new wave of protectionism into the Eurozone’s second-largest economy that could threaten the very fabric of the Eurozone community. The Eurozone economy, on the other hand, has been performing better with inflation on the rise, manufacturing- and service-sector activity picking up steam, leading to an improvement in German business confidence. With only German unemployment, retail sales and Eurozone consumer price reports scheduled for release, the euro will most likely take its cue from U.S. and/or European political headlines.
Sterling finally broke out after consolidating against the U.S. dollar for most of the month but instead of extending higher, it dropped back into its prior range at the end of the week. The move was more technical than fundamental as GBP/USD broke quickly after clearing out stops at 1.2500. The “big news” from the U.K. this week was out of Scotland -- the Scottish government is openly discussing another independence referendum, which after Brexit, they're convinced they could win. Scotland voted to stay in the EU in last June’s referendum, but as a part of the U.K., its future lies in the hands of Theresa May -- they don’t like that. Although a vote wouldn’t be held until 2018, if a second referendum is announced in the next few weeks as some politicians are pressing for, the renewed political uncertainty would be negative for the currency. Looking ahead, the U.K.’s manufacturing-, construction- and service-sector PMI numbers are scheduled for release and a recovery after last month’s muted reports would validate sterling’s recovery.
All three of the commodity currencies held firm last week versus the greenback with the oversold New Zealand dollar leading the gains. Data from New Zealand was mixed, and while service-sector activity gained momentum, producer prices and consumer spending grew at a slower pace while dairy prices fell. Nonetheless, the currency, which has come under heavy selling in recent weeks, rebounded strongly on the back of U.S. dollar weakness. The Canadian and Australian dollars will be in focus this coming week with a Bank of Canada monetary policy announcement and Australia’s fourth-quarter GDP report on the calendar. Although Canada's retail sales missed expectations, consumer prices rose strongly and there’s enough improvement in oil, housing, employment and trade for the central bank to leave policy unchanged. That said,, if the BoC is more cautious, it could cement a bottom in USD/CAD. Aside from the monetary policy announcement, the country’s fourth-quarter GDP report is also scheduled for release. The Australian dollar, on the other hand, should continue to be supported by healthier data with the country’s manufacturing and fourth-quarter GDP numbers likely to show underlying strength in Australia’s economy.