FX Focus: What chance a dollar correction?

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

In recent weeks, more than anything else, we have been highlighting the strong market positioning in the US dollar (USD).  Buyers have been focusing on the clear differentials in yield as well as the respective central bank paths alongside growth divergence between the US and the rest of the world. 

This has been exacerbated by market preference for the greenback as a safe haven, highlighted by Friday's sharp turnaround in the USD after reports that the US could announce tariffs on $200 billion of Chinese goods. 

On this move alone, we note that thin market conditions may have perhaps over-egged the reaction, given the US administration has revealed it is open to fresh trade talks with China. The early Monday price action has reined in some of Friday's USD gains. 

Looking ahead, we see little on the US schedule which could materially add to the US economic outlook ahead of the FOMC meeting next week, where a 25 basis-point (bps) hike is pretty much priced in, in full.  As such, the market will be focusing on hints on December, where odds of a fourth hike look strong at close to 70%.   

Based on this assumption, we could argue that a further near term correction in the USD is highly probable if the series of US data starts to ease off.  

Both producer prices and end product consumer prices came in lower last week to put a sizable dent in the USD.  On Friday, we got softer retail sales figures for August, though the reaction was minimal and traders will point to the positive revisions in July as the key reason further USD selling did not follow.

Weekly claims data, as well as the Markit PMIs for September, are the more senior of release to look to this week, though our eyes are also on the Philly Fed manufacturing index after the sharp drop in August to 11.9. it’s expected to pick back up to 16.3 this month, though this is still some way off the 25.7 reading from July.  

This leaves USD sentiment largely at the fate of the news and headlines on trade.  Liquid markets may be a little more sanguine on what we hear from the US president, with mid-term elections likely to add a negative slant to the greenback in the weeks ahead.  When there is limited data, this could be accentuated, but look for pricing on the December FOMC to have a larger impact from here. 

Based on the fact that yield has driven the USD higher this summer, we will continue to monitor USD/JPY as the stronger gauge for this.  EUR (euro)/USD is where the bulk of USD sentiment is expressed, but last week's European Central Bank (ECB) meeting will have unnerved shorts here and, as we have seen from the Commitment of Traders reports, net positioning is moved modestly in favour of the euro again. 

We doubt this is a major shift at this point, but if ECB president Mario Draghi and the governing council are justified in their view that the eurozone economy will gradually start to recover, then cyclical considerations could start to push the lead spot rate higher if US Q3 growth tails off as many are anticipating.  

Past performance is not a guide to future performance

Last week saw EUR/USD set a base in the mid 1.1500's and, at this stage, we have to consider what could prompt the market to test the weight of selling interest seen in the 1.1700-1.1800 area. 

EU inflation for August has been confirmed at 2%, but, as we have seen in the ECB staff projections, 1.7% is where the average rate is expected to be over the next few years.   

At the end of the week, we get the September series of PMIs, with focus on Germany and the EU as a whole. If we can see a pick up in the respective surveys, there will be grounds for confidence.

Monday morning, the monthly Bundesbank report is still painting a bullish picture on the economy going forward, but it is hard to forecast in the current climate given the erratic trade policy intentions of the US.  German exports and trade has suffered in this period and remains a major drag on the outlook. 

Past performance is not a guide to future performance

If there is some eurozone-based buying of EUR's, we would expect to get some lift in EUR/CHF (Swiss franc) in particular, just as we saw in the last major run up in EUR/USD which aligned with the EUR/CHF move up towards 1.2000.  For now, the cross rate is still trying to set a base in and around the 1.1200 mark. 

EUR/GBP (pound) is also trying to base out, though, naturally, at the hands of fresh optimism over a UK-EU trade deal, sellers are gaining the upper hand at the present time.  Europe is making all the right noises on making concessions towards the UK, the latest being their reported consideration of technology-based solutions to avoid a hard border in Ireland.  

UK PM Theresa May continues to insist that the Chequers plan is still the only way forward so, despite the conflicting views on whether this forms the basis of the UK stance or not, the underlying risk remains that large constituents of parliament are highly critical of these set of proposals.  At some point, the optimism of reaching a' deal will be superceded by the prospects of getting an agreement passed through parliament - something which the PM remains confident of achieving.  

These are all assumptions so, from a risk-based point of view, GBP gains of late are more likely to be limited - certainly into the 1.3300-1.3400 area vs the USD.  As yet, sellers have been quick to show their scepticism in the mid 1.3100's, where 1.3170-80 is the first technical point of resistance.

Past performance is not a guide to future performance

Whether this allows for a EUR/GBP probe lower remains to be seen, though 0.8880-90 is an area we have been watching over the past week or so, and we continue to run into strong demand here. 

Whether this is a platform for higher levels is too early to call.  Price action is giving very little away, and those looking for a major directional bias here will have to wait until either side of 0.8800-0.9100 gives way.  

More UK data to contend with later in the week, starting with inflation on Wednesday.  As long as CPI holds comfortably in the mid 2.0's there is little for the Bank of England to worry about. There is certainly little to discern over the policy outlook with CPI at these levels, with the Monetary Policy Committee maintaining their view on gradual rate hikes - currently at a pace of 25 bps a year.  The risk here is that this picks up a little should we get some clarification on Brexit, though as we have alluded to above, this is some way off. 

UK retail sales is in focus on Thursday and, after a bumper month in July, August is expected to moderate.  Given the bearish outlook on the UK high street, positive surprises come as a welcome breath of fresh air. 

Public finances are reported on Friday, with Chancellor Hammond confident that debt levels will continue to fall this year, though is ever ready to highlight the obvious risks to the economy.