By Kathy Lien, Managing Director of FX Strategy for BK Asset Management.
It was an extremely volatile day for sterling. Taking a look at how GBP/USD traded on an intraday basis, there were at least 3 unexplained spikes that ranged from 50 to 80 pips. GBP is usually more active than other currencies but rarely do we see such wide ranges within a 3-to-5 minute period. Fundamentally, here are number of reasons why GBP should have ended the NY session higher and not lower.
1. Stronger UK wage growth
2. EU Barnier says Brexit deal is realistic within the next 8 weeks
3. BoE Governor Carney gets term extended to 2020
UK data was better than expected and Brexit headlines have been positive. Jobless claims rose less than the previous month, the unemployment rate held steady and most importantly, earnings growth accelerated to 2.6% from 2.4%. This follows Monday’s improvement in the trade balance and stronger than expected July GDP growth. Based on data alone, Tuesday should have been a good day for sterling. EU negotiator Barnier and Irish Prime Minister Varadkar’s comments that a Brexit deal should be done within the next few weeks should have also encouraged more short covering in GBP. The same is true of the UK government’s decision to extend Bank of England Governor Carney’s term to 2020. This eliminates what could have been a significant risk for the pound as the market is comfortable with his steady hand – a change in BoE leadership is the last thing GBP traders need in a period of Brexit uncertainty.
And yet GBP is weak because:
1. Bank of England expected to leave interest rates unchanged on Thursday
2. Positive US data reinforces Fed’s plan to tighten
3. 10-year Treasury yields near 3%
The reason why sterling bears don’t want to give up on their shorts is because they know that the Bank of England has no plans to raise interest rates again this year but that does not mean that the tone of the MPC minutes and BoE statement won’t be hawkish, especially as Brexit talks progress positively. The Fed on the other hand is widely expected to tighten at the end of the month with last week’s NFP and Tuesday’s small business confidence report reinforcing the U.S. economy’s outperformance. Small business confidence hit a record high in August with capital spending and hiring plans increasing significantly. Ten-year Treasury yields are also on the rise, supporting the move in the USD. With all of this in mind, the UK economy is improving and a Brexit deal is near and for all of these reasons, we are still looking for GBP/USD to hit 1.32 although sterling’s strength should be more pronounced versus JPY, AUD and NZD.
Between the rise in Treasury yields, stronger small business confidence and the intensification of trade tensions, the U.S. dollar traded higher against all of the major currencies Tuesday. We expect the greenback to remain firm and trade higher on the back of Wednesday’s Beige Book, which should report improvements in the economy. Producer prices are also expected to rise, creating expectations for stronger CPI on Thursday. As a result, USD/JPY could hit 112 before the end of the week.
Euro shot up to 1.1644 at the start of the London session but spent the rest of the day giving up its gains. Investors have grown less concerned about Italy as Italian yields have been falling for the past week with 2-year rates hitting its lowest level since July on the back of the government’s promise that its budget will satisfy the EU and ease investor concerns. The ZEW surveys were also better than expected with investors growing more confident about the outlook for the German and Eurozone economies. Still, EUR/USD ended the day well below 1.1600 as investors worry about caution from the European Central Bank this week.
USD/CAD on the other hand ended the day at its lows after President Trump said the trade deal with Canada is coming along very well. Oil prices also jumped more than 2.5% but the only thing that matters for the loonie right now is NAFTA. If the U.S. reaches an agreement with Canada before the end of the week, we’ll see USD/CAD back at 1.30. If the talks drag on for another week, the pair will continue to consolidate above 1.31 until an outcome is reached. While the Australian and New Zealand dollars hit fresh multi-year lows versus the greenback, the movements in both currencies have been limited. We think both currencies are vulnerable to further weakness because global trade tensions aren’t easing. Reports that China is asking the WTO for permission to impose sanctions on the U.S. is a sign that the Chinese are not going to sit by idly as President Trumps throws out threats of more sanctions. They plan to retaliate and when they do, it will be very negative for AUD. Not only does intensification of trade tensions boost risk aversion but it directly impacts the Chinese and hence Australian economy. Monday night’s Australian business confidence report shows that local firms are worried – the index dropped to its weakest level since October 2016. Recent increases in mortgage rate hikes also pose a risk to spending and growth. We’ve already seen retail sales stagnate and service-sector activity slow. Between the mortgage rate hikes, global trade tensions and yuan weakness, the outlook for Australia is grim and for these reasons, AUD/USD could extend its slide below 70 cents as US data reinforces the case for Fed tightening.