Fed Still Looks Poised For September Taper

With investors growing less anxious about Syria, U.S. economic data surprising to the upside and 10 year bond yields back at 2.75%, we believe that the Federal Reserve is on track to reduce asset purchases in September. As long as non-farm payrolls grow by more than 150k, the recovery in the labor market should be satisfactory for the Fed who has been looking to reduce stimulus for the past two months. Most policymakers have probably made their decision on when they want to taper and the only question is how much bond purchases should be reduced on a monthly basis. Friday's personal income and personal spending reports are not expected to affect anyone's decision and the same is true of Chicago PMI and revisions to August consumer confidence numbers. Even if the data surprises to the downside (and we think they will because other manufacturing data, retail sales and average hourly earnings have been weak), they need to disappoint in a major way for the central bank to reconsider its plans. The recent uptick in commodity prices should only harden the Fed's plans to taper.

According to the latest economic reports, the U.S. economy expanded by 2.5% in the second quarter, up from an initial estimate of 1.7%. Stronger inventory investment, upward revision to exports and downward revision to imports offset a reduction in spending. This data confirms that the U.S. economy gained momentum for the second straight quarter. Jobless claims also edged slightly lower with only 331k Americans filing for unemployment benefits versus 337k the prior week. As claims in general have been extremely low in the month of August, next week's non-farm payrolls report should show an increase in job growth. Fewer firings have not always translated into stronger hiring but the jobless data is consistent with a continued recovery in the labor market. All of this is good news for the Federal Reserve who has a big decision to make on monetary policy next month.

Meanwhile the broad based rally in global equities and decline in commodity prices also indicate that the market's anxiety around Syria is easing. The Obama Administration has said that it won't act without the support of its allies yet France and the U.K. said they prefer to wait for the results of the UN investigation before deciding whether military strikes are appropriate. Considering that the U.K. Parliament doesn't vote on their participation until early next week, we don't expect any surprises Friday ahead of the long holiday weekend.

EUR: Potential Disappointment In Retail Sales
The worst performing currency Thursday was the euro. While part of its weakness can be blamed on stronger U.S. data, German unemployment numbers also missed expectations. For the first time in three months, the level of unemployment in the euro zone's largest economy increased. As previously indicated by the PMI reports, job growth in the service sector was offset by job losses in manufacturing. Consumer prices also stagnated and these reasons could limit the level optimism from the European Central Bank who meets next week. A closer look at the intraday price action of the euro reveals that the sell off in the currency pair started at the London open when European investors drove the U.S. dollar higher against all of the major currencies. There was no news to fuel this specific demand which suggestions European traders were adjusting their positions in response to the ongoing sentiment on Syria. Looking ahead, German retail sales are scheduled for release on Friday and unfortunately we believe that the data could add pressure on the euro. According to the latest consumer confidence report, the outlook for September deteriorated. Labor market conditions have worsened and a retail survey by Markit Economics found little change in spending on a month to month basis. The retail PMI index remains in expansionary territory but the level of expansion did not change. This leads us to believe that, consumer spending may not have rebounded as much as economists hope for in the month of July.

GBP: Surge In Business Confidence
It has been seven consecutive trading days since we have seen a rally in the GBP/USD but this is due in large part to USD strength and not GBP weakness because sterling saw nice gains against the EUR Thursday. While the losses for the GBP/USD off the 1.5717 high have been modest, the currency pair has nonetheless quietly grinded lower despite stronger data and optimism from Mark Carney. The new central bank governor has made it clear that the latest improvements in the economy are not enough for the BoE to even talk about let alone seriously consider raising interest rates. In an interview with Nottingham Post this morning, Carney reiterated that, "raising rates too soon would choke the recovery." According to the central bank's forecasts, rates will remain unchanged until 2016 but we believe this timing will be reevaluated if growth exceeds expectations over the next two years. Businesses in the U.K. are already feeling more optimistic according to Lloyds of London who reported that confidence hit its highest level since February 2010. We believe this positive sentiment will be seen in the GfK Consumer Confidence index. Housing market numbers are scheduled for release on Friday and a slow but continued recovery in the sector is expected.

CAD: Contraction In June?
The Canadian, Australian and New Zealand dollars resumed their slide against the greenback on the heels of weaker economic data. In Canada, the current account deficit widened to -$14.6B from -$13.4B in the second quarter, a dynamic that won't bode well for Friday's Q2 GDP numbers. Unlike some other countries where most surprises have been to the upside, in Canada economic conditions have been weakening because of slower growth in the U.S., floods in Alberta and a construction strike in Quebec. The confluence of factors weighed on retail sales and manufacturing activity and is expected to have caused a contraction in GDP in the month of June and a significant slowdown in Q2 GDP growth. The New Zealand dollar also experienced healthy losses after a nosedive in business confidence this month. The ANZ Business Confidence Index dropped from 52.8 to 48.1 but the pullback needs to be taken in the context of last month's report, which hit a multi-decade high. Australian capital expenditures on the other hand rebounded in the second quarter, helping the AUD avoid losses as steep as the CAD and NZD.

JPY: Signs Of Weakness In Japan?
The Japanese Yen traded lower against most of the major currencies Thursday as markets and risk appetite around the world continue to recover. Sentiment has improved but that does not mean that the outlook for Japan has brightened. Last night's economic reports raise fresh concerns about the strength of the country's recovery. Retail sales fell 1.8% in the month of July, a level of weakness more severe than what economists anticipated. The drop in spending does not bode well for Prime Minister Abe's plans for a consumption tax. If spending growth has already slowed, a higher consumption tax could make the Japanese more frugal. Yet if Abe does not introduce the tax it will weaken Japan's fiscal position. Meanwhile for the second week in a row, Japanese investors sold foreign bonds. If this selling turns into a sustained trend, USD/JPY could have a difficult time rallying. Thursday night was slated to be another busy one in Japan with PMI, CPI, jobless rate, overall household spending and industrial production numbers scheduled for release. Of these reports, our focus will be on industrial production because it can serve as a indicator of future economic activity.

Kathy Lien, Managing Director of FX Strategy for BK Asset Management.