By Kathy Lien, Managing Director of FX Strategy for BK Asset Management.
There Could be Another Pre-FOMC Dip in the Dollar
Investors bought U.S. dollars against all of the major currencies shrugging off Tuesday morning’s softer U.S. economic reports. To many, this demand is counterintuitive because weaker data lowers the chance of a Federal Reserve rate hike and what we are seeing is a lot of profit taking and position adjustments ahead of the announcement. There hasn’t been this much debate, uncertainty and division for a FOMC meeting in years. However we believe this strength is unwarranted, particularly given Monday night’s comments from Bank of Japan Governor Kuroda. The market was looking for some indication that the BoJ was preparing for more QE, but Kuroda failed to touch on that possibility. Thus we believe that USD/JPY could trade back below 120 before the FOMC rate decision. We're not looking for a big decline, just a move down to 119.50. On FOMC day, all positions should be neutralized before the announcement.
Every piece of U.S. data released Tuesday -- from retail sales to the Empire State manufacturing index and industrial production -- missed expectations, making it increasingly difficult for the Federal Reserve to justify raising interest rates this week. In August, consumer-spending growth slowed to 0.2% from 0.7% and excluding autos and gas, to 0.3%. Some analysts point to the upward revisions in July and strength in the control group but at 0.4%, this still represents a slowdown from the previous month. We also saw weakness in the manufacturing sector with the Empire State manufacturing index printing at -14.67 versus -0.5 expected. Industrial production dropped -0.4%, two times worse than anticipated. The U.S. economy is still performing well but these latest reports harden the case for delaying the first rate hike.
The drop in Chinese stocks is also problematic. Overnight, the Shanghai Composite Index fell 3.5% to 3005 and a break below 3000 opens the door to fresh 2-year lows. There’s no argument that the weakness in China complicates the Federal Reserve’s decision because they know that raising rates will cause spillover into China and emerging markets. The best time for the Fed to raise rates is when there is minimal uncertainty and significant stability. Unfortunately that's not the environment that we live in today. Yet by not raising rates the Fed risks falling behind the curve and being forced to hike before the crucial holiday spending period. Even with Tuesday’s reports, U.S. growth is still steady enough for the Fed to raise rates – hence their conundrum. We are advising clients to sell U.S. dollars ahead of FOMC, square up on the day of the event and wait for new opportunities after the announcement.
Normally Bank of Japan monetary policy announcements have a limited impact on the Japanese yen, but the currency traded higher across the board after Governor Kuroda refrained from adding fuel to speculation that the central bank could increase Quantitative Easing in the near future. Going into the monetary policy meeting, a small group of investors believed that the BoJ could increase QE and a larger group expected the central bank to align their views with government officials who recently called for more stimulus. While the BoJ downgraded its assessment of the economy, Kuroda said he expects the economy to recover modestly and inflation trends to improve. Despite China’s troubles, he sees the economy continuing to grow in a stable manner and indicates that the Chinese government has plenty of room for more policy action. The BoJ could still expand its program at a later time, but for now they're in no rush to ease policy further.
As we anticipated, GBP/USD experienced its steepest decline in 7 trading days on weak inflation data. Consumer prices grew 0.2%, but on an annualized basis, price growth was flat with core CPI year over year growth slowing to 1% from 1.2%. Between lower fuel prices and a slow increase in clothing prices, the official rate of inflation in the U.K. is 0%. The Bank of England focuses on core price growth but it will be difficult to ignore the overall price trends. The recent rebound in sterling suggests that some traders are still banking on an early 2016 rate hike but given Tuesday’s CPI and PPI reports along with last week’s PMI misses, the case for an early 2016 rate hike has weakened. U.K. employment numbers are scheduled for release Wednesday and based on KPMG’s report on private placements and the employment component of the PMI manufacturing index, the odds favor another downside surprise.
EUR/USD also traded lower on the back of U.S. dollar strength and a weaker German ZEW survey. While investors were more optimistic about current conditions in Germany, the problems in China made them sanguine on the outlook. The expectations component of the ZEW survey dropped to its lowest level in 10 months. However the weaker euro continues to lend support to trade activity with the Eurozone trade surplus rising to 22.4B from 21.9B. Eurozone consumer prices are scheduled for release Wednesday.
USD/CAD was lifted by U.S. dollar strength with the loonie shrugging off an increase in existing home sales and rebound in oil prices. Technically, a triangle is forming in USD/CAD with the increasingly tight consolidation pointing to an imminent breakout that could be triggered by FOMC.
NZD/USD bounced off its lows on Tuesday after dairy prices rose 16.5%, the strongest increase in at least 5 months. Prices jumped by at least 10% in each of the last 3 auctions fueling hope that we have finally seen a bottom in dairy. However it remains to be seen if this price trend can last because it was driven by a decline in supply and strong seasonal demand from China. The New Zealand dollar remained in play Tuesday night ahead of current account figures. The sharp deterioration in trade activity between April and June points to downside surprise that could renew the decline in the New Zealand dollar.