Will the Dollar Recovery Last?

For the first time since late December, we’ve finally had a week where the U.S. dollar did not decline. The Dollar Index ended the last week of January marginally higher after losing as much as 6% of its value over a 7-week period. All of the major currencies were hit by profit taking with the Australian dollar and Japanese yen experiencing the steepest losses. Euro, sterling and the New Zealand dollars held up the best but their rallies came to a halt as the dollar recovered. Looking ahead, the market’s appetite for U.S. dollars could take a back seat to global growth and central bank meetings. None of the major central banks are expected to change policy but with currencies rising strongly over the past 2 months, everyone will be watching for FX comments. The biggest event will be the Bank of England’s Quarterly Inflation Report but the Reserve Bank of Australia and New Zealand’s rate decisions could also have a significant impact on the Australian and New Zealand dollars. These big events just skirt the surface of all the important releases on next week’s calendar.

It is still too soon though to declare victory by dollar bulls who are just beginning to wrest control from the bears. For some pairs that turned later like GBP/USD, USD/CAD and NZD/USD, we could see a more significant reversal at the start of the new week but there could be slower gains in USD/JPY, EUR/USD and AUD/USD. A hawkish FOMC, strong non-farm payrolls and a sharp rise in 10 year Treasury yields fueled the dollar’s recovery. Janet Yellen’s tenure at the Fed is over and she left the market with an optimistic FOMC statement with a more hawkish view for inflation. Their positive outlook was reinforced by Friday’s non-farm payrolls report which showed job growth rising to 200K in January, the unemployment rate steady and wages growing by 0.3%. This was accompanied by an upward revision in December payrolls and wage growth. There’s no question that the labor market is strong and at this pace, the unemployment rate could fall further in the coming months. However with the market already pricing in 100% chance of a March hike, Friday’s release did not change those views. The most important U.S. economic report on next week’s calendar is ISM non-manufacturing and with non-farm payrolls released, it should only have a limited impact on the dollar but given the strength of NFPs, service sector activity should be stronger.

Instead how central banks feel about the recent gains in their currencies will be the main focus. The week kicks off with the Reserve Bank of Australia and New Zealand’s rate decisions followed by the Bank of England meeting and Quarterly Inflation Report. Other key releases are sprinkled in between. Starting with Australia, the economy has actually been performing pretty well since the last monetary policy meeting. Thanks to a healthy labor market and further job growth, retail sales and consumer confidence are up. Business are also more confident despite a slowdown in service and construction sector activity. The manufacturing sector seems to be chugging along as the Chinese economy performs better than expected. Inflation also increased strongly year over year despite a softer quarterly rise. These reports suggest that the RBA will have no immediate desire to raise interest rates but they could overlook the 4.5% rise in AUD/USD since their last meeting. When they last met, they expressed concerns about the currency’s strength posing a drag on growth and inflation so this week investors will be looking to see if stronger language is used and if so AUD/USD could extend its decline to .7750. Before RBA, Australia’s PMI services, trade balance and retail sales reports will be released which will help to shape the market’s expectations for the policy meeting. Afterwards on Thursday evening, we have the Quarterly Statement on Monetary Policy. AUD/USD is vulnerable to additional profit taking unless the RBA statement or data is overwhelmingly positive.

As for the New Zealand dollar, it has been nearly 3 months since the Reserve Bank of New Zealand last met and since then, the New Zealand dollar appreciated 5.5% versus the greenback and 2% versus the Australian dollar. Data has been softer with retail sales growth slowing materially, manufacturing activity easing, business confidence falling and inflation slowing. There are some bright spots in housing and trade with the trade balance unexpectedly turning to surplus in December on the back of strong exports. At the last RBNZ meeting, NZD/USD traded higher after the central bank moved forward their forecast for the next rate hike to the second quarter of 2019 from the third. While the data suggests that the RBNZ should be slightly less optimistic and more critical of the currency’s strength, the RBNZ will usher in a new central bank governor in March (Adrian Orr) as right now, Grant Spencer is only acting governor so he may not want to rock the boat. Regardless, the RBNZ meeting will be an important event to watch. Q4 employment numbers will be released the day before and could help shape expectations for the rate decision. Friday’s sell-off marked the strongest one-day sell-off in NZD/USD since October and the decline is likely to continue in the coming week.

While there’s no monetary policy announcement on Canada’s calendar, the Canadian dollar will also be on the move with the trade balance, IVEY PMI and labor market report scheduled for release. Recent data has been mostly softer but there could be a recovery in trade and IVEY PMI after the past month’s weaker readings. Job growth on the other hand has been very strong and it may finally be time for a correction. Like the New Zealand dollar, the Canadian dollar experienced its strongest one day decline in nearly two months and a move as sharp as this one typically has continuation. We see USD/CAD rebounding to 1.2500 and possibly even 1.26 in the coming week if Canadian data surprises to the downside.

The biggest event though should be the Bank of England’s announcement. Aside from a regular rate decision, their Quarterly Inflation Report is also scheduled for release. The BoE raised interest rates towards the end of last year and investors are keen to know when they will do so again. There was no mention about timing at their last meeting, but the Monetary Policy Committee likes to provide more guidance when the Quarterly Inflation Report is released. Since December, there hasn’t been any major improvement or deterioration in the UK economy. Retail sales fell sharply but inflation ticked up slightly, labor market conditions held steady and wages grew at a healthy pace. Manufacturing and construction sector activity slowed but economists are looking for service sector activity to accelerate (the report is due on Monday). Most importantly, GBP is up 5% against the dollar and 10 year Gilt yields are up 25bp since their last meeting, which represents a tightening of financial market conditions. The tone of the Quarterly report should be optimistic but there will be reservations given the change in market dynamics. The BoE may not want to risk driving GBP/USD significantly higher. If they are unambiguously positive, talking about additional hikes in the coming months, GBP/USD could hit 1.43 but if the tone of the report or Carney’s speech is cautious, GBP/USD could fall below 1.40.

Last but certainly not least, the euro is still one of the best performing currencies. Compared to other G7 currencies, its pullback on Friday was modest and even with that decline EUR/USD is flat for the week. Meanwhile it is up strongly versus the Australian dollar, Japanese Yen and Canadian dollar. EUR/JPY and EUR/CAD rose to their highest level in 2 years. The economy is recovering and the effect of a strong euro on inflation has been limited. As a result, Eurozone policymakers have become more tolerant of the rising currency and more eager to end asset purchases. There’s very little Eurozone data in the coming week to threaten the currency’s positive outlook and for that reason we expect euro to continue to outperform other major currencies (barring any surprises from central banks). EUR/USD on the other hand is due for a pullback – if the pair closes below 1.24, we could see a steeper decline towards 1.2275 but the sell-off will invite bargain hunters. The Swiss Franc also rose to its strongest level in 2.5 years versus the dollar despite threats of Swiss National Bank intervention. The move was driven by the combination of dollar weakness and stronger Swiss retail sales / manufacturing data. Although it is tempting to pick a bottom in USD/CHF, the pair needs to rise above 94 cents for bulls to get excited.