Dollar: The Risk of US Q3 GDP

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Daily FX Market Roundup 11-06-13

Dollar: The Risk of US Q3 GDP
ECB Preview: Europe Does Not Want to Become the Next Japan
GBP Soars on Stronger IP, No Action Expected from BoE
CAD: Surprise Jump in IVEY PMI
AUD: Supported by Stronger Trade, Employment Next
NZD: Extends Gains as Market Digests Stronger Data
JPY: BoJ Minutes Show Comfort with Monetary Policy

Dollar: The Risk of US Q3 GDP

The U.S. dollar traded lower against all of the major currencies today with the exception of the Japanese Yen. This performance is consistent with the rise in equities and decline in Treasuries. With the Dow Jones Industrial Average closing at a record high today and the S&P 500 flirting with its own historic level, investors are optimistic which could be a big problem if tomorrow’s Q3 GDP report falls short of expectations. Economists are looking for U.S. growth to have slowed from 2.5% to 2% in the third quarter but after solid manufacturing and service sector ISM numbers, investors are not as worried about sluggish growth. Even if the recovery lost momentum, the data shows that the economy was not hit hard by the government shutdown and should therefore bounce back strongly over the next few months. While we believe this view is overoptimistic, we can’t ignore the fact that Federal Reserve officials also feel that the recovery is steady enough to warrant a reduction in stimulus in the near future. When it comes to handicapping GDP, the 2 most important components of the report are consumer spending and trade. In the third quarter, the trade balance improved slightly but retail sales growth was very weak. Without a pickup in consumer spending, it will be very difficult for the economy to gain momentum. So while the Fed is focused on jobs, we need to see demand improve this holiday shopping season to be convinced that the economy can handle a reduction in stimulus. Nonetheless the risk for tomorrow’s report is to the upside because most investors are still positioned for tapering in March 2014 or later. If U.S. GDP growth exceeds 2.4%, we expect to see a renewed demand for dollars that could drive USD/JPY above 99. However if GDP growth is less than 2%, stocks could give up some of today’s gains and the dollar could trickle lower. Unless GDP growth is less than 1.5%, we don’t expect a deep sell-off in the dollar because GDP is a stale release. The Challenger jobs cuts report and U.S. leading index were released today. Both reports had very little impact on the U.S. dollar but it is worth noting that job cut announcements fell 4.2% in the month of October and this is a sign of weaker labor market conditions.

ECB Preview: Europe Does Not Want to Become the Next Japan

The European Central Bank’s monetary policy announcement on Thursday is one the most important event risks this week. While we do not expect the central bank to cut interest rates, we believe ECB Governor Mario Draghi will prepare the market for lower rates in December. If we are right, ECB dovishness should be enough to drive EUR/USD to a fresh 6 week low. With consumer price growth slowing and producer prices in negative territory, deflation is becoming a growing risk for the Eurozone. Policymakers in Europe are pressured to act because they do not want Europe to become the next Japan. Over the past few decades, we have seen how messy deflation can be and how difficult it is to reverse if it becomes entrenched. Rising unemployment and sluggish growth has made it very difficult for businesses to raise prices and unless the labor market improves quickly, we may not see much upside in price pressures. Currently, CPI in the euro area is growing at its slowest pace in almost 4 years. According to estimates from the European Union’s statistics office, the annualized rate of inflation dropped to 0.7% in October from 1.1% in September. The annualized rate of producer price growth is -0.9%. Considering that the ECB’s target is 2% inflation, the drop in price growth will pressure the central bank to ease. Europe could certainly use another dose of stimulus. Although the recession officially ended in the region, growth has been very weak, particularly in the peripheral economies, making deflation a serious problem in that part of the region. As we saw this morning, consumer spending is also a problem and unfortunately that weakness has extended beyond the periphery into the core economies (Germany and France). If not for the upward revision in PMI services, the ECB may consider a rate cut tomorrow more seriously.

However we expect the ECB to wait until December to cut interest rates. The central bank likes to prepare the market for major changes in monetary policy and given that only 3 out of the 70 economists surveyed by Bloomberg expect a rate cut tomorrow, the market is clearly not positioned for a move. By setting expectations for lower rates on Thursday, the ECB will give investors plenty of time to discount the move, so that hopefully it will lead to only a mild reaction in the EUR/USD when the change is actually made. The central bank will also be releasing its staff forecasts in December. A lot of work is put into these projections and many policymakers will want to wait to see the outcome of the exercise before deciding to change monetary policy. A rate cut is needed sooner or later because bringing inflation from its current levels back up to 2% won’t be easy without looser monetary policy. The first step is to boost growth and a rate cut followed by another LTRO next year will go a long way in achieving that goal. The prospect of easier monetary policy in the Eurozone alone is negative for the euro but when combined with the prospect of less stimulus from the Federal Reserve, we could see a far more significant sell-off in the currency. The current support level in the EUR/USD is 1.3480, the 38.2% Fibonnaci retracement 2008 to 2010 sell-off and then the 6 week low of 1.3440 but dovishness by the ECB should be enough to drive the currency pair to 1.34 which should only be short term support for the pair. The more significant support level is down at the 200-day SMA near 1.32.

GBP Soars on Stronger IP, No Action Expected from BoE

The British pound extended its gains against the U.S. dollar on the back of stronger economic data. Industrial production rose 0.9% in the month of September after falling 1.1% the previous month. Manufacturing production also increased 1.2%, erasing the past month’s decline. Compared to the market’s expectations, the surprise was not large but with the manufacturing PMI index being the only PMI report to decline in October, the increase suggests that there is still decent momentum in the sector. The Bank of England meets tomorrow and they will be encouraged to see the improvements in data. However, no changes in monetary policy are expected with the positive surprises in the summer starting fade in the fall. The BoE’s monetary policy is still dovish but far less so than the ECB and RBA. For this reason, we expect continued gains in sterling versus the EUR and AUD, unless of course Mario Draghi surprises the market by downplaying the drop in inflation and the need for easier monetary policy.

CAD: Surprise Jump in IVEY PMI

Stronger than expected economic data drove the Canadian, Australian and New Zealand dollars higher against the greenback. Despite the Bank of Canada’s decision to drop its bias to raise rates, manufacturing activity rose strongly in the month of October. The IVEY PMI index jumped from 51.9 to 62.8, reaching its highest level since May. Unfortunately the increase was driven entirely by more supplier deliveries because the employment, inventory and price subcomponents of the report all declined. Also building permits grew less than expected which can explain the muted reaction in the CAD. While USD/CAD could drop below 1.04, we expect losses to be limited. Australia also reported a very significant improvement in trade activity. The country’s trade deficit was originally expected to narrow from -693M to -500M but instead it rose to -284M on the back of lower imports. The country’s labor market report is scheduled for release this evening and we are also looking for stronger job growth. The New Zealand dollar continues to be supported by last night’s employment report. If you recall, the level of employment rose by 1.2% in the third quarter, pushing the unemployment rate down to 6.2% from 6.4%. AUD/NZD recovered earlier losses but given the divergence between Australian and New Zealand’s monetary policy direction, we still believe that the currency pair could test 1.12 but a bounce to 1.1450 may be seen first especially if Australia reports a significant increase in job growth.

JPY: BoJ Minutes Show Comfort with Monetary Policy

The Japanese Yen traded lower against all of the major currencies today. Overnight, the Bank of Japan released the minutes from its October meeting and there were no surprises. The minutes confirmed that the BoJ is confident in its monetary policy and optimistic about the outlook for the economy. BoJ members felt that the economy is recovering moderately and they expect this pace to continue. They also believe that prices will rise gradually although the pace of CPI growth could pause if exports recover at a slower pace. Most of the government’s concerns center around external and not domestic risks. The central bank is not expected to alter monetary policy unless the consumption tax takes a big bite out of the economy. Looking ahead, we expect the Yen crosses to trade on the market’s reaction to the U.S. GDP report and the ECB’s rate decision.

Kathy Lien
Managing Director

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