By Kathy Lien, Managing Director of FX Strategy for BK Asset Management.
2017 has been defined by strong, exaggerated moves in many major currencies and after months of relentless uptrends, we are finally beginning to see signs of a top. Lower highs and lower lows or consolidation followed by rejection of key levels for currency pairs like GBP/USD, AUD/USD and USD/CAD has many investors wondering if deeper corrections lie ahead. To answer this question, we have to recognize that U.S. dollar's weakness is the primary reason why the euro and Australian dollar are up more than 10% year to date. What’s remarkable about these uptrends is that they occurred while the Federal Reserve was raising interest rates, which means investors were skeptical about the central bank’s hawkishness from the very beginning. Friday's U.S. nonfarm payrolls report eases some of those concerns but based on the lackluster rally in USD/JPY investors still aren’t convinced that another rate hike is warranted. A total of 209K jobs were created in July, driving the unemployment rate down to 4.3% from 4.4%. Average hourly earnings growth accelerated to 0.3% from 0.2%. These numbers are good enough to stem the slide in the dollar and ease gains in overbought currencies. In other words, the pullback that we’ve seen over the past week in pairs like EUR/USD, GBP/USD and AUD/USD is a top that should lead to further losses. The outlook for the U.S. dollar is not the only reason why a number of currencies may have peaked. Central banks are growing worried about the negative implications of their strong currencies and have toned down their level of hawkishness as a result. With very few major economic reports on next week’s calendar, the loss of momentum that we saw this week could continue into the new one. The only piece of U.S. data worth watching next week is Friday’s inflation report and before that the focus will be on Fed speak.
Sterling is the most vulnerable to a deep correction as there was nothing positive in the most recent Bank of England Quarterly Inflation report and monetary policy announcement. The central bank voted 6-2 to leave interest rates unchanged, cut their forecasts for GDP and wage growth and expressed concerns about a “smooth transition to a new economic relationship with the EU.” Governor Carney said the bank’s forecast revisions factor in “uncertainty about the eventual shape of the U.K.’s relationship with the EU, which weighs on the decisions of businesses and households and pulls down both demand and supply.” They also felt that the weaker GBP was the only reason why inflation was hotter in the beginning of the year and the recent reversal should ease price pressures. As BoE member Broadbent pointed out, U.K. inflation is nearing its peak. Carney also sees growth picking up later on investment and trade with the economy supply capacity rising at a modest rate but their forecasts are predicated on the first rate hike happening in Q3 of 2018, which is too far out for a market that was hoping for a move this year. The disappointment that came out of the central bank meeting overshadowed the stronger PMIs. Given how much GBP/USD rose in the last 4 months (from 1.24 to 1.3250), the tone of the central bank and the healthy U.S. nonfarm payrolls report means 1.3270 is most likely the top in GBP/USD. On a technical basis, this is also where the 20-day SMA on the monthly chart and the 23.6% Fib retracement of the 2014 to 2016 sell-off converge, making it the perfect stopping point for the pair after a prolonged rally that took it from 1.20 in October of last year to 1.3270 this month. Next week’s industrial production and trade balance reports are not significant enough to change the market’s appetite for sterling.
The euro also pulled back sharply on Friday and some traders may find it interesting that the decline on a percentage basis was greater than sterling and the Australian dollar even though fundamentals in those countries are less positive but the explanation is simple. Many of the other currencies lost momentum earlier this month and the euro is finally catching up. At the end of the day we expect the euro to outperform up until the point where the ECB begins to talk it down. Unlike other countries there’s been more positive than negative data and the central bank is widely expected to upgrade their economic forecasts next month and could begin tapering asset purchases. The latest economic reports show German factory orders rising strongly but retail demand is slowing according to the PMIs. While we are bullish euro, the currency is up 10% this year and that will eventually catch up to the economy. We have already seen some areas of weakness and suspect that next month’s economic reports may not be as good as the last one. Either way, for the time being until there is data weakness, the euro should outperform other currencies. Germany’s industrial production and trade balance are due for release next week and they're not expected to have a significant impact on the currency. The next big focus will be ECB President Draghi’ speech at Jackson Hole later this month. EUR/USD has support between 1.1630 and 1.1670. The Swiss franc extended its losses this week, driving EUR/CHF above 1.15. Outside of profit taking there is very fundamental or technical reason for the pair’s trend to change.
The commodity currencies are also prime candidates for deeper corrections. Despite relatively healthy Canadian labor data, USD/CAD closed above 1.26 for the first time in 2 weeks and this move opens the door to a stronger rally to 1.2800. Sellers are expected to swoop in quickly as the fundamentals still favor USD/CAD weakness. After 2 strong months for the labor market another 10K jobs were added in the month of June, 35K of which were full time. This improvement combined with a downtick in participation took the unemployment rate down to its lowest level since 2008. Oil prices also increased and Canadian yields ticked higher, a sign that bond traders were pleased with the latest reports. A large part of the Canadian’s dollar weakness had to with the rebound in the U.S. dollar but a weaker than expected trade deficit and a lower IVEY PMI report also gave loonie traders an excuse to take profits on short USD/CAD positions.
The Reserve Bank of Australia hasn’t been shy about expressing its concerns about the strong currency, which poses significant risks for the currency at a time when the U.S. dollar is rebounding and commodity currencies are losing momentum. Although this week’s Australian economic reports were mostly better than expected with retail sales, building approvals, service and manufacturing PMI either increasing from the month prior or beating expectations, the Reserve Bank’s cautiousness and its lowered 2017 GDP forecast tells us exactly how the central bank feels about the economy. RBA Governor Lowe warned that a continued rise in the Australian dollar would depress prices and limit growth and employment. Their warning turned into action as the central bank cut their 2017 GDP forecast by 0.5% to a range of 2-3% due to the Australian dollar’s “modest dampening effect on the forecast for growth.” Looking ahead, we anticipate a deeper correction that could take AUD/USD as low as 78 cents. August is typically a challenging month for the currency, which dropped 10 of the past 12 Augusts.
There are no major Australian economic reports scheduled for release next week but the New Zealand dollar will be in focus with the Reserve Bank’s Quarterly monetary policy announcement on the calendar. The RBNZ is widely expected to leave rates unchanged but the recent trend of softer data suggests that the central bank could be less hawkish. When the central bank last met rather than express concern about a currency that had appreciated 4% that month versus the U.S. dollar, they sent NZD even higher by saying the “lower currency would help rebalance growth.” Since NZD/USD rose another 3 cents r and data continued to weaken. Job losses were reported in the second quarter, business activity and consumer confidence is down, while inflation, dairy and food prices declined. The only area of strength was housing and spending which seems to be holding steady. In light of all this it will be difficult for the RBNZ to maintain their positive views and to prevent NZD from slipping further versus the U.S. dollar.