Dollar Bulls Put Up a Good Fight But…

Daily FX Market Roundup 09.15.17

It was a challenging week for the U.S. dollar but dollar bulls put up a good fight. Despite a weaker retail sales report and the news that North Korea fired another missile over Japan, the dollar ended the week higher against all of the major currencies except for the British pound. The record breaking level of U.S. stocks and the persistent rise in Treasury yields are primary reasons for the dollar’s resilience. Investors are hoping that the Federal Reserve will share the European Central Bank and the Bank of England’s hawkishness when they meet next week. However it will be difficult for them to do so with retail sales falling -0.2% in the month of August. In the last 4 months there was only one month of positive spending growth, which is reflection of the weakness and not strength of the U.S. economy.

This is important as we head into the new week as nothing will be more market moving than the Federal Reserve’s monetary policy announcement. At this 2 day meeting the central bank will also provide its latest economic projections followed by a press conference with Janet Yellen. Having already raised interest rates twice in 2017, the Fed is widely expected to start unwinding their Quantitative Easing program in September by reducing the balance sheet. They are not ready to start selling bonds but as many U.S. policymakers have indicated, they will stop reinvesting their proceeds. In many ways this balance sheet runoff is a form of tightening that sends the central bank down the path of more normal monetary policy but announcing a run-off of the balance sheet by itself won’t be enough to satisfy dollar bulls. Investors are waiting to see if Fed Chair Janet Yellen drops any hints about the central bank’s plans for tightening in December. Currently, Fed Fund futures show the market pricing in slightly less than even (46%) odds for another rate hike this year and unfortunately we don’t think those odds will change much with the FOMC meeting next week. Since the last monetary policy meeting, we’ve seen more improvements than deterioration in the U.S. economy but part of those positive surprises including the uptick in consumer prices is distorted by the hurricanes.

The problem is that U.S. policymakers haven’t made up their minds about what to do in December either. In the past month, Hurricane Harvey and Irma set the economy back and we won’t start to see their effects until next month’s economic releases. After that, the Fed will need to wait to see how quickly economic activity snaps back before taking action which means they may not know how well the economy is doing until November. Even then if the recovery is strong it is hard to say whether it will last which is why we believe the central bank will refrain from providing any clear guidance this month. We know that rates need to continue to rise especially with U.S. stocks at record highs but subdued wage growth and the effects of Harvey should leave the Fed on the bench for the time being. As a result we expect the greenback to give up some of its recent gains before and after the rate decision. USD/JPY raced to a high of 111.33 this past week but with significant resistance near that level, we expect the pair to drop below 110 in the week ahead.

The best performing currency this past week was sterling, which hit a 15 month high. More gains are possible as there is always a period of adjustment when investors learn that their expectations are misaligned with the central bank’s views. That’s exactly what happened with the Bank of England this past week. After lowering their GDP and wage growth forecasts in August, they sent rate hike odds below 20% but with their guidance on Thursday, the chance of tightening before the end of the year shot up to 66%. The Bank of England voted 7-2 to leave interest rates unchanged and what got the market really excited was their comment that “a majority of monetary policy members see scope for stimulus reduction in the coming months.” This tells us the BoE is preparing to join the ECB and the Fed in removing stimulus. Although third quarter growth is expected to be subdued, inflation has been hot with annualized CPI growth hitting 2.9% in the month of August. Rather than downplay the increase, the BoE said they see inflation exceeding 3% next month, well beyond their 2% target. At the same time, “eroding slack reduces their tolerance for faster inflation,” which is why the central bank believes the market is underpricing the chance of a rate hike. The tone of the BoE statement was unambiguously hawkish and BoE Governor Carney confirmed that he is among the majority on the MPC who see the need to change stimulus. As such, we expect further gains in GBP, helped by the upcoming retail sales. It may not be long before we see GBP/USD at 1.38 with even stronger gains for GBP versus AUD and NZD.

Euro on the other hand had a difficult week but that was due to the lack of economic data. The currency’s flows were driven entirely by the market’s appetite for U.S. dollars and British pounds. Both of those currencies performed well and by extension the euro suffered. Although there are a number of important pieces of Eurozone data on the calendar next week, the market’s focus on FOMC means that euro could still end up taking a backseat. With that in mind, it is important remember that the ECB made their monetary policy plans very clear. They expect to make an announcement on reducing bond purchases next month, kicking off a gradual phase on policy normalization. In terms of data, Eurozone consumer prices, PMIs and the German ZEW survey are scheduled for release. Of these reports, the PMIs are the most important and they will be released on Friday. This means the front of the week, EUR/USD could be driven by dollar flows but towards the end, the market may shift its focus back to the Eurozone economy. We still like buying euros on dips and see another move to 1.21 more likely than a decline to 1.17. Also, to no one’s surprise, the Swiss National Bank also left monetary policy unchanged. While they see the Franc’s significant overvaluation as reduced, they view the situation in the FX markets as fragile and have pledged to intervene in the FX markets if needed. They also cut their 2017 GDP forecast to just under 1% from 1.5%, which is a sign of their concerns about the economy. The SNB will be one of the last central banks to raise interest rates resulting in underperformance of the Franc.

All 3 commodity currencies struggled this past week on the back of a stronger U.S. dollar. The Australian dollar was the worst performer, which may be surprising considering their healthy labor market report. More than 54K jobs were created in the month of August, the strongest since March. With full and part time jobs rising, the labor market is one of the strongest parts of Australia’s economy. It should only be a matter of time before the jobless rate improves as well. Unfortunately other data such as business confidence was not as firm and so after flaming out two Fridays ago, AUD/USD dropped below 80 cents. We believe that it should find support near current levels with the next move in AUD driven by the RBA minutes and a speech from RBA Governor Lowe.

For the New Zealand dollar, second quarter GDP, another dairy auction and the upcoming election on September 23rd will be the main focus in the coming week. The currency lost value against the U.S. dollar with little economic data to drive the move. Card spending was slightly weaker in August but consumer confidence improved. Unlike many other major central banks, the Reserve Bank of New Zealand has no immediate plans to raise interest rates or reduce stimulus. Next week’s second quarter GDP report could be better but the RBNZ’s generally cautious outlook could continue to cast a dark cloud on the currency.

The Canadian dollar continues to be one of the strongest currencies. Although it ended this past week slightly lower than where it started, it struggled to rise above 1.22. Between the recovery in oil prices (crude hit $50 a barrel), solid Canadian data and a hawkish central bank that could raise interest rates one more time this year, investors still prefer the loonie and refuse to give up their long trades. Retail sales and consumer prices are scheduled for release on Friday. If they are strong and validate the BoC’s hawkish bias, we could see USD/CAD test 1.20.