Are USD/JPY & EUR/USD Poised for More Losses?
Daily FX Market Roundup 10.12.18
By Kathy Lien, Managing Director of FX Strategy for BK Asset Management
In 2 trading days, the Dow Jones Industrial Average lost more than 1,300 points and the S&P500 fell over 5%. The last time there was a decline of this magnitude was in February and on the day when the UK voted to leave the European Union. Both times the declines were short-lived and with stocks easing its decline on Friday, many investors are wondering if buyers will return just as quickly this time around. The dollar is falling because investors are looking at the decline in stocks as a U.S. dollar story. The Federal Reserve raised interest rates by 75bp this year and is expected to tighten again in December. For next year, the market is starting to price in 3 rounds of tightening as even the dovish of doves (Fed President Evans) feel that the central bank needs to take rates 50bp above neutral. No one including the Fed really knows what the neutral rate is but earlier this month Fed Chair Powell said we are a “long way from neutral” which suggests that it is at least 3% so 50bp above neutral would mean 3.5%. While getting to this rate will take some time, investors are worried that these rate hikes will create an economic crisis. We know that rising rates is a big problem for the housing market but trade wars combined with higher interest rates makes businesses and investors more conservative which could lead to lasting weakness in U.S. equities. The past 2 years have been great for U.S. stocks and the recent decline gives investors a good reason to lighten up on their positions. For all of these reasons, buyers may not return as quickly because U.S. interest rates were 75bp lower in February and Brexit was viewed as the UK’s problem.
However the meltdown in equities shouldn’t change the course for currencies because a contraction in the U.S. economy is bad for all countries. If the sell-off in stocks is rooted in the prospect of higher U.S. interest rates, then rising yields in U.S. should keep the dollar attractive. The Fed should still be the most aggressive central bank next year and for now, the signs of weakness in the U.S. economy have been minimal. Inflation and consumer confidence surprised to the downside last week but price pressures are strong according to the Fed. The real test for the dollar comes next week when retail sales and the FOMC minutes are scheduled for release. If consumer spending is strong, the dollar should resume its rise as investors are reminded of the outperformance in the U.S. economy. The FOMC minutes should also be hawkish. If USD/JPY extends its slide, there’s support between 111.80 and 111.25.
With stocks recovering on Friday, all of the other major currencies pulled back versus the greenback. The euro found a bottom this past week but it is too soon to declare victory for the bulls. The rally was modest, it was not supported by data and the EUR/USD rejected the 20 and 100-day simple moving averages. While the trade surplus in Germany grew, exports and imports declined while industrial production contracted. We’re beginning to see some softness in German data and that could negatively affect this week’s investor sentiment (ZEW) report. The only thing that the euro has going for it are hawkish comments from ECB officials. A number of them including Mario Draghi have been talking about the upside risks to inflation. Despite last week’s decline, oil prices have been strong and the weaker euro drives up price pressures. This message should not ignored because the longer the euro remains weak, the louder these comments will be.
The primary focus for sterling is Brexit and data is only a distraction. This week’s softer GDP and trade balance report had very little impact on the currency. Instead GBP rallied at the start of the week after the EU’s Chief Brexit negotiator Barnier said they could have a deal next week and fell at the end on reports that Prime Minister won’t agree to being trapped in a customs union. The clock is ticking and a deal is drawing close but having been burned by false hopes, investors are ignoring the conflicting headlines and waiting for official confirmation. When a deal is announced, GBP will soar but until that happens investors are skeptical. Employment, inflation and retail sales data are scheduled for release this week and while all of these are big reports, Brexit progress or setbacks will still be the primary driver of GBP flows.