By Kathy Lien, Managing Director of FX Strategy for BK Asset Management.
Except for two very brief periods of volatility, it was an extremely quiet day in the forex market. The greenback reversed from earlier gains to end the day lower against all of the major currencies. The biggest story was the pop in EUR and GBP at 9:05AM ET followed by the 11:20AM ET drop in sterling. Before, during and after these moves, EUR/USD and GBP/USD consolidated in tight ranges. The 60-pip rally in EUR/USD and 150-pip jump in GBP/USD was sparked by reports that Germany and the U.K. will drop key Brexit demands and concede to a relationship with less details. Unfortunately, about 2 hours later Germany said its position on Brexit wa unchanged. Sterling dropped instantaneously but slowly trended upward, ending the day above 1.29. The reason why sterling could extend its gains is because Brexit negotiations are ongoing and while the Irish border issue is a big deal, between the recent comments from EU chief Brexit negotiator Barnier and today’s rumor, we may be getting closer to a Brexit deal. The European Union is more willing to negotiate with the UK than in the past and headlines like Tuesday's on Germany fosters hope for a breakthrough. As a result, buyers are cautiously returning to sterling and as the pair rallies, their demand will trigger more short covering. Speculative short positions in GBP/USD are at their highest level since 2017 and we have barely seen any short covering. If GBP/USD rises back above 1.2935, we should see a stronger recovery toward 1.30. UK PMIs were also better than expected with service sector activity growing at a faster pace in August. The Bank of England’s inflation expectations survey is due for release tomorrow and given the weakness of sterling and the high level of commodity prices, higher inflation expectations are expected.
Buyers are also slowly returning to the euro. The latest Eurozone economic reports were mixed with the downward revision to Germany’s composite PMI index offset by the upward revision to the Eurozone’s report. Retail sales in the region’s largest economy also contracted at a faster pace in July. The reason why the euro received such a boost from the possibility of a Brexit deal is because a resolution for the UK also eases the uncertainty for German businesses working with UK companies. The main reason why we think the euro could extend its gains is because in the last 48 hours, we’ve seen a significant decline in Italian bond yields. Having reached a high of 3.2% at the end of last month, 10 year Italian bond yields are now hovering near 2.9%. The government’s reassurance that the EU’s deficit rules will be respected is finally resonating among investors who are also relieved that Italy avoided a ratings downgrade by Fitch last week. Technically, EUR/USD is trading back above the 50-day SMA and if it clears 1.1650, it should be smooth sailing to 1.17.
The U.S. dollar is in focus on Thursday with ADP and non-manufacturing ISM numbers scheduled for release. This is nonfarm payrolls week and these reports can tell us a lot about how the labor market is doing. Job growth last month was weak and this deterioration coincided with a sharp drop in non-manufacturing ISM. So if the index continues to fall, traders may need to beware of another soft release. However if service-sector activity rebounds – and we think it will – USD/JPY could resume its rise toward 112. Wednesday morning’s trade balance, which was close to expectations, had very little impact on the currency. The same was true of Fed President Bullard and Kashakari’s more cautions comments.
Meanwhile, the Bank of Canada’s monetary policy announcement proved to be a big dud. USD/CAD barely reacted to the decision as the central bank balanced it view that higher rates will be needed with its concerns for trade tensions. According to the BoC, recent data reinforces the view that higher rates will be warranted as it expects inflation to move back toward its 2% target in early 2019. BoC feels that the economy is evolving as expected and with core CPI firmly around 2%, the economy is near capacity. The only thing that worries the bank is trade talks. If not for NAFTA uncertainty, the BoC statement would have been far more hawkish with the central bank laying out plans for a rate hike next month. However even with its concerns about trade, the tone of the monetary policy statement is positive. Rate-hike expectations for October sit firmly at 82% thanks partly to Wednesday morning’s much stronger-than-expected trade balance and labor productivity reports. Economists had been looking for the trade deficit to widen from -740 million to -1 billion but instead it shrank to -110 million on the back of rising exports. Although Canada has made it clear that it will only accept a deal that is good for Canada, foreign minister Freeland's return to trade talks is a promising sign. The latest comments from President Trump also suggest that a decision or outcome will be known in the next one-to-three days. USD/CAD has had a remarkable run over the past 4 days and the hope for a deal should take the pair back down to 1.31. Technically, we are finally seeing the rally in USD/CAD lose momentum with the 4-hour charts showing a potential pullback to at least 1.3135.
The Australian and New Zealand dollars also traded sharply higher on the back of U.S. dollar weakness with the deeply oversold NZD/USD leading the recovery. There was no specific news to support kiwi’s recovery but the Australian dollar was driven higher by stronger-than-expected Q2 GDP. Australia’s economy expanded by 0.9% in the second quarter and this improvement drove the annualized pace of growth up to 3.4% from 3.2%. Both currencies appear poised for a stronger recovery as even a 1 cent move would keep its downtrends intact.