By Kathy Lien, Managing Director of FX Strategy for BK Asset Management.
Over the past few weeks, the U.S. dollar has struggled despite progress on tax reform and the prospect of a Federal Reserve rate hike next month. The market may be convinced that the Federal Reserve will raise interest rates in December, but the most recent economic reports have been far from encouraging. Retail sales growth beat expectations but at 0.2% the increase was weak, especially compared to the 1.9% rise in September. CPI also eased due to lower food and energy costs while manufacturing activity in the NY and Philadelphia regions pulled back. These numbers won’t stop the Fed from raising interest rates in December but they could lead to a more cautious guidance for 2019. That, along with tax reform, is what investors are worried about, which explains why the dollar has struggled to rally despite the prospect of another rate hike. We say often that tax reform is the Trump Administration and the U.S. economy’s greatest opportunity for growth and while the House voted to pass its tax bill this week, the Senate is where the real battle will take place.
While the House and the Senate Finance Committees passed their respective versions of the bill, last-minute changes that tie in the Affordable Care Act and make individual tax cuts temporary (corporate tax cuts permanent) have not been received well by Democrats and even some Republicans. Senators Ron Johnson and Susan Collins became the first Republicans to come out against the Senate bill and this could become a serious problem as the GOP cannot afford to lose more than 2 votes. They have only a 52-48 majority in the Senate and no Democrats are willing to support the bill. Also, the Senate and House still have to reconcile their bills before they are combined into a final plan that is voted on by both houses of Congress. So it will still be a long road ahead before President Trump signs tax reform into law. With the Senate going on recess, we probably won’t get any meaningful progress in the week ahead and that could contain USD's volatility. Aside from the FOMC minutes, which should be dollar-positive, there are no major U.S. economic reports scheduled for release. Fed Chair Janet Yellen speaks on Tuesday evening at the Stern School of Business but we don’t expect anything market-moving, especially as everyone realizes that she has limited impact on monetary policy next year (her term expires in February). Reports that North Korea is on an aggressive schedule to develop a submarine launched ballistic missile rattled the dollar this week and served as a hard reminder that geopolitical risks still hang over the currency.
The euro is the only currency that could see meaningful volatility in the week ahead with Eurozone PMIs and the German IFO report scheduled for release. Having hit a 3-week high this week, EUR/USD rejected the rally but now appears to be stabilizing above 1.1750. In addition to data, ECB President Draghi is scheduled to speak and his colleagues made it clear they believe policy needs to remain accommodative even though trade activity and investor confidence improved. Just this past week, ECB member Mersch said the euro area still needs monetary stimulus and ECB would not hesitate to act if needed as its tool box is not limited to asset purchases. ECB member Praet agreed that the central bank needs to remain patient and persistent on policy as inflation is subdued despite signs of growth. The bottom line is they have no intention of raising interest rates until late next year, which means regardless of how quickly the Federal Reserve hikes again, it will be more hawkish than the ECB so risk of a correction in EUR/USD remains. We are also looking for next week’s PMI, producer prices and IFO report to weaken and if we are right, it would support the case for a deeper pullback in the currency.
For the past 2 weeks, sterling traded in a narrow 200-pip range against the U.S. dollar. It broke out of that range on Friday but there was no major follow through. Interestingly enough, it was not U.K. data but U.S. dollar weakness that pushed sterling higher. This week’s U.K. economic reports were mixed. Consumer price growth slowed in October and the same was true of wage growth. Retail sales grew 0.3%, which is not great especially considering that spending rose only 0.1% excluding auto fuel purchases. Still, investors were relieved that spending did not contract for a second month in a row. The pocketbooks of Britons are still being pinched, there’s no progress on Brexit talks and there are different voices calling for a second Brexit vote, which is wishful thinking. However having just raised interest rates earlier this month, Bank of England Governor Carney’s view that further tightening will be needed in coming years was enough to prevent sterling from falling. With that in mind, we think the next hike is still some time away and the market agrees as another quarter-point move is not priced in for 2018. There’s only a 72% chance of a hike by December of next year with odds not rising beyond 50% until October. In the coming week, the Chancellor will present the budget to Parliament but outside of that, there aren’t any market-moving events on the U.K. calendar. Technically, while GBP/USD ended the week near its highs, it needs to rise strongly above 1.3230, the 100-week SMA to open the door for a stronger move above 1.33.
All 3 commodity currencies were under pressure this week with the New Zealand dollar leading the losses. Interestingly enough there was very little NZD data on the calendar but what was released hurt more than helped the currency. Consumer confidence declined further in November, business activity slowed according to the PMI and unlike consumer prices, producer prices eased in the third quarter. So while the New Zealand dollar may be oversold, fundamentals provide little reason for a rally. Given recent developments, next week’s third-quarter retail sales and trade balance report should also be softer, which could keep NZD under pressure. We expect the currency to experience its greatest underperformance against sterling and the Australian dollar. Meanwhile, AUD/USD, it hit a 5-month low this week despite mostly stronger data. According to the latest reports, business confidence increased, the unemployment rate dropped to its lowest level in 4 years and full-time work is up strongly. However wage growth failed to accelerate in Q3, consumer confidence ticked lower and consumer inflation expectations declined. The Australian dollar responded poorly to all of these reports as investors know that the numbers will keep the Reserve Bank of Australia firmly in its seat. USD/CAD drifted higher throughout the week although the gains were modest. Data was mostly weaker with existing home sales, house prices and consumer price growth slowing. These reports support the Bank of Canada’s cautious monetary policy outlook and the idea that it has no immediate plans to raise interest rates. This week’s NAFTA meeting has yet to yield any meaningful results. They will continue through Tuesday so the risk is still to the downside for the loonie as the chance of more contention strongly outweighs the chance of an agreement. For this reason, we still think that USD/CAD will trade higher in the coming week, especially if retail sales miss.