By Kathy Lien, Managing Director of FX Strategy for BK Asset Management.
We are coming off the heels of an interesting week for the U.S. dollar. The greenback hit a near-term bottom against European currencies but struggled to hold onto its gains versus the Japanese yen and commodity currencies. The mighty buck lost its luster after the Federal Reserve minutes, which cast doubt on the central bank’s hawkishness. The problem was U.S. data and the FOMC minutes, which failed to bolster the market’s confidence in a June hike. Although Bloomberg has Fed Fund futures showing a 100% chance of tightening next month and existing home sales tumbled in April, the trade deficit widened and jobless claims increased. Most importantly, according to the Fed minutes, U.S. policymakers are worried about the slow progress on inflation with some preferring to wait for evidence that the slowdown is transitory before taking action. So even if the Fed hikes next month, it will probably indicate one and done. The inconsistency in data and market expectations makes next week’s event risks particularly important. In many ways, the dollar lives or dies by this month’s nonfarm payrolls this month. If the jobs report is good, which means nonfarm payrolls increase, the unemployment rate holds steady and average hourly earnings rise at last month’s pace or better, the uncertainty about the Fed’s hawkishness will fade quickly, leading to a strong dollar recovery. However if any part of this Friday’s report disappoints, investors will start to unwind their long dollar trades – or worse, start shorting dollars ahead of the June FOMC meeting. The Beige Book report is due for release on Wednesday and it will provide some clues on how the labor market is doing but the real test for the greenback will be NFPs as the outcome could set the tone for how the dollar trades for the next few weeks. Support in USD/JPY is at 110.30 and even if it rallies, it needs to clear 112.15 to remove the pair’s negative bias.
Five weeks have passed since EUR/USD gapped up from 1.0730 to 1.0880. There is a saying that gaps are meant to be filled and after such a long period of time, traders are still itching to drive the pair lower. After racing above 1.12, the currency pair ended the week below this key level. The near-term political risks have faded and the latest economic reports were positive for the euro – German investor confidence rose strongly in May, the Eurozone’s trade surplus hit a 3-month high and there was no revision to the Eurozone’s Q1 GDP and French CPI reports. Even ECB President Draghi acknowledged the euro-area recovery as resilient and increasingly broad based. But EUR/USD has been unable to extend its gains for 2 main reasons – the first is slower inflation growth (prices are already rising at a more gradual rate and the rise in the currency puts further pressure on inflation). The second is the diverging views of the ECB and Federal Reserve. Mario Draghi made it clear that now is not the time to talk taper whereas practically every U.S. policymaker who spoke this month (aside from Kashkari) believes that further policy normalization is necessary. Let's not forget that the Fed is the only major central bank talking about tightening and could increase interest rates by another 50bp this year. Of course, Friday’s U.S. job report could affect the market’s expectations and if the data is weak, it would be wildly positive for the euro. If positive, we could see EUR/USD head for 1.10. Eurozone inflation, confidence and German labor data are due for release and softer price pressures would reinforce the recent pullback in the euro.
The Australian dollar also struggled this past week, bucking the trend of strength of the other commodity currencies. The move was driven partly by U.S. dollar strength, but largely because of rating-agency action. The downward course of the currency was set by S&P’s decision to lower the credit scores of nearly a dozen financial institutions at the start of the week. The losses were exacerbated by Moody’s downgrade of China and lower leading indicators. We know that the RBA is concerned about the economy and the property market is becoming a growing problem in Australia as domestic and external (Chinese) demand begins to ease. Chinese growth in general is a concern and it has a direct impact on Australia. Next week’s retail sales and manufacturing PMI numbers will play a central role in stemming the slide in the currency and reversing some of the divergences. Given the sharp rise in the sales component of the performance of services index, we believe that spending rebounded in April after falling in March. The levels to watch for AUD/USD are 74 cents on the downside and 0.7520 on the upside.
In contrast, the Canadian and New Zealand dollars performed extremely well versus the greenback and the Australian dollar. Both currencies rose strongly against the U.S. dollar this past week with the loonie soaring on the Bank of Canada as the kiwi jumped on positive fundamental developments. These currencies appear poised for more gains after key levels break. For USD/CAD, the move below 1.35 opens the door to a deeper slide below 1.34. For NZD/USD, the break above 0.7050 puts the pair on track to test 71 cents. The number to watch next week for Canada is GDP. If growth slowed in March, or in the first quarter, we will see a move back above 1.35. However if growth accelerates, the downside target could be hit. Although the Bank of Canada recognized the improvements in the economy this past week and its views sent the loonie sharply higher, it is still very concerned about growth and inflation as excess capacity and uncertainties hamper economic activity. Some of these worries could be a result of weaker GDP growth in the first 3 months of the year. OPEC extended its production cuts for another 6 months, which caused oil and CAD to fall. Still, crude reversed its losses on Friday, helping the Canadian dollar recover.
The New Zealand economy, on the other hand, continues to recover as indicated by last week’s strong trade surplus and increased milk payout forecast from Fronterra. The price of milk is extremely important because it is New Zealand's number-one export. In fact, exports rose by the most in 2 years according to the latest report driving the surplus to its highest level since March 2015. What made the report particularly positive was the fact that dairy was not the only sector that saw gains: exports of log and wine also increased significantly, which should reduce the central bank’s concerns about the impact of a strong currency. Investors were also satisfied with the government’s latest budget. Looking ahead, there are no major New Zealand economic reports on the calendar this week outside of the RBNZ’s Financial Stability Report.
Finally, sterling was the week’s worst-performing currency. The terrible tragedy in Manchester combined with concern about Brexit negotiations prevented GBP/USD from breaking above 1.30. The currency pair rose above this level on numerous occasions only to be met by heavy selling. First-quarter GDP growth was revised lower (which is rare for the U.K.) and loans for house purchases eased. While this is significant, the market is still more concerned about the country’s escalated terror alert level and the tough negotiations with the E.U. Last week started with talk that the UK could walk away from Brexit negotiations if it is forced to pay its massive exit bill of as much as $100 Billion. At the same time, the EU refuses to back down from its hard negotiating stance, making the path forward difficult to see. Prime Minister May called for elections in June and her popularity has been negatively affected by some of the recent events in the country. GBP/USD is now trading below the 20-day SMA and is likely to drop to 1.2700.