By Kathy Lien, Managing Director of FX Strategy for BK Asset Management.
The U.S. dollar traded sharply higher against all of the major currencies Wednesday on the back of the Federal Reserve’s monetary policy announcement. No one was surprised by the Fed’s 25bp rate hike but the dot-plot forecast shows policymakers looking for 3 rate hikes in 2017. This view is more aggressive than the 50bp move they forecasted back in September and single-handedly sent USD/JPY above 116. Fearing that Janet Yellen would downplay this forecast, traders refrained from driving the pair above 117 until after the Fed chair began to speak and when she called the extra quarter-point hike a “very modest adjustment”, they realized that she was not going to refute this view. That line, along with her confidence in the economy, sent the U.S. dollar and Treasury yields sharply higher. Ten-year rates jumped more than 10bp at one stage and held onto most of its gains at the end of the North American session. Fed fund futures are now pricing in a 70% chance of another rate hike in June and a 100% chance of more tightening in the second half of the year. So not only was Yellen unfazed by the potential negative economic impact of higher yields, but she felt confident enough in the economy to signal that the tightening program will continue in the New Year. This view should keep the dollar bid into year end and while there could be some profit taking, the pullbacks will be shallow. The next stop for USD/JPY is 120, although this key level may not be tested until 2017.
In the meantime, investors will be watching yields and data carefully to determine how quickly the central bank will raise interest rates next year. The latest U.S. economic reports highlight the areas of vulnerability. Retail sales grew a meager 0.1% in November and spending in October was revised down to 0.6% from 0.8%. Excluding autos and gas, spending growth slowed to 0.2% from 0.5%. Inflation is up with producer prices jumping 0.4% but industrial production turned negative in November, falling by a more than expected 0.4%. Consumer prices, the Empire State and Philadelphia Fed manufacturing indices are scheduled for release along with the weekly jobless claims report. The sharp rise in PPI suggests that CPI could also beat expectations but these reports probably won’t alter the current momentum in the dollar.
Meanwhile, the focus now shifts to the Bank of England’s monetary policy announcement on Thursday. No changes are expected but the central bank’s tone should have a meaningful impact on the currency. Although Wednesday morning’s U.K. labor-market report was mixed with employment falling for the first time in more than a year for the three months to October, average hourly earnings rose strongly and the unemployment rate held steady at 4.8%. More importantly, the table below highlights the widespread improvements in the U.K. economy since BoE's last monetary policy meeting. Retail sales rose strongly in October, wage growth accelerated, consumer prices are on the rise and the PMI composite index increased, reflecting stronger economic activity. Consumer confidence is down slightly and manufacturing activity slowed. Still, sterling's weakness should go a long way in boosting the central bank’s outlook for inflation and growth. Stocks have also performed extremely well, which should give Governor Carney the confidence to tout the improvements in the U.K. economy and reiterate the central bank’s warning that it has only limited tolerance for an overshoot of inflation. When he first made these comments, they were perceived as positive for sterling and the interpretation is likely persist if these views are emphasized again. More specifically, less-dovish comments could drive GBP/USD to 1.28 and EUR/GBP 0.83. U.K. retail sales are also on the calendar but they will take a backseat to BoE.
The Swiss National Bank also has a monetary policy announcement and is widely expected to leave interest rates at a record low. In fact, rates are expected to remain negative until 2018. Switzerland is extremely sensitive to its exchange rate and the euro's recent weakness drove EUR/CHF below 1.07. While the currency is trading above that level at this time, the strong franc makes it extremely difficult for the SNB not to worry about the impact on the economy. Expect the SNB to also suggest that further intervention is possible if EUR/CHF continues to fall. The euro made a run for 1.05 and spent only a brief moment below this key level. There’s clearly significant orders preventing a deeper slide but we believe it is only a matter of time before this level gives. Two-year German yields are at record lows and industrial production continues to fall. Eurozone PMIs are scheduled for release Thursday and the weaker currency should continue to lend support to the economy, but that may not help the currency.
All three of the commodity currencies fell victim to U.S. dollar strength, shedding over 1 percent against the greenback. Australian employment numbers were due Wednesday evening and we expect an uptick in job growth with the employment component of manufacturing and services ticking higher. Despite lower inventories, the Canadian dollar traded lower as oil prices shrugged off the news. Canadian yields also fell sharply and the combination of oil, yields and slower house price growth sent USD/CAD sharply higher. The New Zealand dollar extended its losses on the back of a weaker business manufacturing PMI index and a lower value of all buildings. Despite their strong moves, the commodity currencies are vulnerable to additional losses, particularly the Canadian and New Zealand dollars.