By Kathy Lien, Managing Director of FX Strategy for BK Asset Management.
It was a great week to be long U.S. dollars. The greenback traded higher against all of the major currencies. The Australian dollar experienced the steepest losses but the Canadian dollar and euro also traded sharply lower. The Japanese yen and British pound were the only currencies that managed to hold steady in the face of USD’s gains but even they ended the week slightly lower. Nearly every piece of U.S. data released over the past week from third-quarter GDP growth to jobless claims, durable goods, new-home sales and the Markit PMI indices were better than expected but good data was not the only reason for the dollar’s rise. The Republican Party also made substantial progress on tax reform with the House passing the budget, which clears the way for the House GOP leader to release a draft of the tax bill next Wednesday. Considering that they were able to pass the budget blueprint without Democratic support, it is now realistic to expect the Republican-led Congress to have the bill introduced, debated and approved by the end of November. Tax reform is the U.S. economy’s biggest opportunity for growth and by overcoming recent hurdles, the Trump Administration breathed new life into the U.S. dollar. Between the introduction of the tax bill on November 1 and the prospect of a Fed-chair announcement before Trump takes off to Asia on November 3, we believe next week will be another good week for the U.S. dollar.
Political developments may dominate the headlines, but there are also many U.S. economic reports on next week’s calendar that will shed light on how well the U.S. economy snapped back after the hurricanes. Personal income, personal spending, the Chicago PMI report, consumer confidence, the ISM manufacturing and non-manufacturing reports are scheduled for release along with nonfarm payrolls and the Federal Reserve’s November monetary policy announcement. As we’ve seen widespread improvements in the U.S. economy since the September meeting, the monetary policy statement should be hawkish enough to reinforce the Fed’s view that another rate hike this year is appropriate. When they last met, the dot-plot forecast had 11 Fed officials projecting one more hike in 2017. There’s no press conference associated with this FOMC meeting but we have every reason to believe that the tone will be positive for the dollar.
As for the labor market report, believe it or not, payrolls are expected to rise by 310K after falling -33K the previous month. If job growth meets expectations, it would be the single-best month for payroll growth since May 2015. Of course, such a strong number would be largely credited to post-hurricane adjustments. However we are skeptical of the labor market’s ability to meet such a high bar. After hurricane Katrina in 2005, job growth only rebounded by 56K after falling -35K the previous month. The month after there was a substantial increase but even the 215K rise is smaller than this month’s forecast. So the October jobs report may not be so stellar, particularly since average hourly earnings growth is expected to slow after rising strongly in September. For the U.S. dollar this means that we expect strength in the front of the week with profit taking toward the end. It is perfectly reasonable to expect USD/JPY to break 115 and USD/CHF to hit 1.01.
The European Central Bank’s monetary policy announcement drove the euro to its lowest level in 3 months. This is also the first time since April that EUR/USD has fallen below the 100-day simple moving average, which means the next stop could be 1.15. While next week’s German inflation and labor-market reports are important, they will not move the needle for the ECB who has made it clear that interest rates won’t be increased until October 2018 at the earliest. After cutting their asset-purchase program by 30 billion and running this new size from January to September, Mario Draghi said they would keep rates at current levels well past the end of QE, which means that the ECB’s first rate hike won’t come until the third quarter – far longer than most investors have the patience for. Once that comment was made, nothing else mattered, including Draghi’s positive comments on growth, wages and core inflation. So the same will be true for next week’s German economic reports. While we expect inflation to rise and German job growth to be strong, it won’t affect the central bank or the market’s expectations for tightening. At the same time, Spain’s political troubles will continue to plague the currency while U.S. dollar strength edges the euro lower. Catalonia’s Parliament officially declared independence, Spanish Prime Minister Rajoy declared this a criminal act and the Spanish Senate gave the central government direct rule over the region. Almost immediately, Rajoy fired the entire Catalan government from Catalan regional President Puigdemont to the police chief. He also dissolved the Catalan parliament and called for a new election on December 21. While the central government wants to start with a clean slate, there’s no doubt there will be repercussions as independence supporters head to the streets and the polls.
Meanwhile, it will be a big week for both the U.S. dollar and sterling. The Bank of England has a monetary policy announcement on the calendar and the market is pricing in an 89% chance of a rate hike. We’re not so sure that the BoE is ready to move, especially given the recent weakness in retail sales, slowdown in CPI growth and larger trade deficit but investors clearly feel differently. They believe that even if the BoE stands pat in November, they’ll hike in December with year-end rate-hike expectations hovering just over 90%. These hawkish views were driven by the minutes from last month’s BoE meeting, which revealed that a majority of MPC members see “scope for stimulus reduction in the coming months.” On that same day, BoE Governor Carney confirmed that not only have the odds of a hike increased but he is among the majority on the MPC who see the need to change stimulus. While a hike could wait until December, many investors anticipate the move happening in November because it will be accompanied by a Quarterly Inflation Report and press conference that would give Carney the opportunity to explain the change and manage the market’s future expectations. If the BoE hikes, it would be wildly positive for sterling and could take the currency up to 1.33. Sterling will still rise if they leave rates unchanged but strongly suggest that a hike is coming in December. But if they leave rates steady and suggest that a hike could still be a few meetings away, we could see GBP/USD below 1.30. Aside from the BoE announcements, the U.K.’s manufacturing and service-sector PMI reports are also due for release in the coming week.
The commodity currencies are also vulnerable to additional weakness as the fundamentals change. Although the biggest change in monetary policy expectations came from Canada, the Australian and New Zealand dollars experienced the greatest weakness. AUD/USD did not see one positive day this past week and instead fell to its lowest level in 3 months. Softer-than-expected consumer and producer price reports reinforced the Reserve Bank of Australia’s neutral policy stance. The RBA has no reason to raise interest rates and in an environment of a rising U.S. dollar, this was a good enough reason for investors to offload their long AUD/USD positions. In the coming week, Australia’s manufacturing- and service-sector PMI reports are due for release along with retail sales and trade balance. These reports and China’s PMI numbers will give us a better sense of how the Australian economy is doing along with whether the currency deserves to be trading as poorly as it recently has. We suspect that Australia is not doing as poorly as its peers, which means that the currency could stabilize, especially against currencies other than the U.S. dollar. The New Zealand dollar continues to be pressured by the new government’s policies, namely the Reserve Bank’s unemployment mandate that adds a significant hurdle to rate hikes. The country’s trade deficit was also larger than anticipated and contributed to NZD/USD’s test of its 5-month low. In the coming week, third quarter labor-market data is scheduled for release and a significant improvement would be needed to stem the slide in the currency.
Last but certainly not least, USD/CAD staged a strong rally this past week after the Bank of Canada left interest rates unchanged at 1% and said they need to be “cautious with future rate increases.” The BoC was widely expected to keep rates steady but some market participants were hoping for optimism. While the BoC raised its 2017 and 2018 forecasts substantially and said less monetary stimulus will likely be required over time, investors zeroed in on their concerns about the downside risks to inflation, excess capacity in the labor market, softness in wage growth, the elevated level of household debt and how it would be affected by higher rates. Their preoccupation with lower inflation means they have no plans to raise interest rates again this year. In response, December rate-hike expectations fell from 44% to 30%. Looking ahead, Canadian GDP and labor-market numbers are due for release next week but the market may be more interested to see if Carney and Wilkins reveal anything new in their testimonies before the Senate and Finance Committee.