FX Focus: Potential for further shocks

Foreign exchange analyst Rajan Dhall runs through the big issues that will drive the major currency pairs this week.

That the US dollar (USD) has regained some significant ground in recent months is not a surprise - indeed, it was something we anticipated at the start of the year.  However, the speed of its rise has taken many by surprise.  

When we look back to the start of the year, the Federal Reserve was still in a position to raise rates by two or three times over 2018, yet the focus on the budget and trade deficits overpowered the divergent rate path of the Fed and the rest of the major central banks around the world.  

Since then, however, inflation and growth in the US have both accelerated and, along with other market dynamics, have sent the USD into orbit.  

When we consider the overstretched bearish sentiment and positioning against the USD in early 2018 and largely in favour of the euro (EUR), we can see why the downturn has been as aggressive as it has.  That said, once we hit 1.1500 we saw a little more two-way activity before traders took advantage of thin market conditions to take out these lows and attack the next key area of support into the upper 1.1200's.  

Momentum has a key part to play in exchange rate developments, so the broad-based dash for dollars, exacerbated by the flight to safety from emerging markets, naturally keeps the upside for the USD alive. But, over the last few weeks, we have been considering just how much of the positive economic outperformance has been priced in.  

From a valuation basis, fair value levels have been wiped out in the EUR.  This comes in at around 1.2400-1.2500, which we reached at the start of the year. Political fractures within the eurozone as well as the sea change in government in Italy have all served to highlight the vulnerabilities in Europe and the single currency project. So, it is safe to say that any fresh rush back to the upside is off the table for now.  

Against this, however, the traditional economic theory does suggest exchange rate strength on the basis of current accounts, and in the eurozone, it is widening again.  This process has been a very steady one and steeped in uncertainty given the impact of a full-blown trade war which looks to have been averted between the US and Europe at least.  

Between China it looks a different matter, though lower-level officials are set to meet this week to try and calm any further escalation in tariffs which look set to hurt both economies eventually.  

Past performance is not a guide to future performance

Given the Chinese yuan (CNY) rate has devalued by over 10% since the start of the year, this will have dampened the impact of US levies on Chinese goods, so the inverse will eventually impact on US exports and trade, which up until recently have seen the trade gap narrowing.  This has since stalled. 

Looking to the week ahead, there is little in the way of any meaningful data which can confirm Q3 growth will continue at a similar pace to the previous one.  Conservative estimates seem to be converging around the 3% mark, which would underpin the expectations of a Fed hike in Sep, though as yet, Dec is still in the balance at just over 50% and it is here that some of the strength in the USD could be tamed.  

Financial conditions tighten with such excessive gains in the currency, so what we have now is a potential dynamic of the market 'pricing out' a fourth rate hike this year! 

Jackson Hole at the end of the week is expected to cover productivity and the sluggish pace of wage growth, something which is plaguing all the major central banks, who are watching job gains continuing all the while.  Fed chair Powell is not expected to speak until Friday, but we expect few direct references to specific monetary policy matters with all central bank speakers likely to keep discussions generic.  

US durable goods give us the only key insight in the current state of the economy, though this data is pretty volatile.  Any weakness here though could have a little more impact than normal given some anticipated softening in the pace of US investment and growth.  

Notable was last week's Philly Fed manufacturing index which fell sharply from 25.7 to 11.9.  New orders contracted significantly with the prices paid and employment indices also notably lower, with CapEx spending also slowing.  Could this be the impact of a stronger USD and higher rates combined?

In Europe, focus will be on the manufacturing and services PMIs.  Their release will not come until Thursday, so until then we expect EUR/USD to gravitate inside 1.1300-1.1500, and there is a very good chance we remain inside these limits at the end of the week. 

Even so, if the surveys start to show some fresh energy - let's not forget that all indices remain firmly in expansionary territory - then it may start to solidify expectations that the EUR could stabilise, underlining the support seen at the lows posted last week.  

Italy's run-in with the EU on budgetary limits will continue to dampen sentiment to some degree, with the Bund vs BTP spread a key driver of EUR/USD trade earlier in the year.  Greece has formally ended its bailout program this week, but the focus is very much on any destabilising effects from Italy's government spending plans.  

In the UK, Brexit news was pretty light this weekend.  What little there was offered little fresh insight into the progress of the talks which continue behind the scenes.  Talk of growing support for a second referendum on the proposed deal and/or a fresh vote has been permeating through the market with little impact on the pound (GBP).  

What is key now is if the EU does agree on the proposals put forward by Theresa May in her Chequers plan, how parliament will react. The outcome of the talks are complicated by the prospect of severe opposition from the pro-Brexit camp, led by Jacob Rees Mogg, Boris Johnson and a host of other key names keen to promote Leave means Leave. 

It is hard to see any real calm for GBP in the meantime, but we do sense a reluctance to push back to 1.2500, which now looks to be a line in the sand, with undervaluation supporting it.  We based out in the mid 1.2600's last week.  Whether this can hold depends as much on the USD as it does on GBP sentiment expressed through the EUR cross rate.

Past performance is not a guide to future performance

EUR/GBP met with strong support at 0.8900 last week, and the upturn coincided with a EUR/USD recovery also, which will have a stronger impact due to real money forces in thin summer markets.  

UK public finances in the spotlight on Tuesday, and if net borrowing falls in Jul as expected, this is another feather in the cap of the UK after some strong spending data last week added to support for the pound.