FX Focus: Why Fed mistake could trigger next downturn

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

After a weekend of notable disappointment over the G7 meeting, the markets are once again choosing to ignore the potential risks ahead - obviously that of an escalation of trade wars.  

At present, the prospect of this developing into something more sinister seems more likely against Europe and Canada, while Mexico is also under threat as all three regions have had the metals tariffs imposed on them as of 1 June. 

President Trump made a number of uncomfortable tweets in the aftermath of the summit in Canada, and his comments on the host nation’s PM Trudeau were the more unsavoury, calling the premier “dishonest and weak”.  

This will naturally hamper progress on the NAFTA talks, which seemed to be going well according to reports on all sides, but the convivial mood has been tossed out the window as the US president insists on taking an aggressive stance on the trade imbalances which have drawn his and his administrations ire.  

Needless to say, the president failed to endorse the G7 communique, adding to the disagreement within the leading nations by calling for Russia to be welcomed back in, despite widespread condemnation over its behaviour in Ukraine and Syria as well as “crossing” international boundaries as it were. 

Going forward, we place greater emphasis in later comments from president Trump that his administration will now consider tariffs on foreign automobiles and, given previous references made about German cars, it is clear to see that European ties are also being stretched at the present time. Japan is also in the spot light given heavy car imports. 

With plenty of cross border activity and production on US cars with Canada, there is also more scope for unrest with its closest neighbour and ally, despite having made progress on the rules of origin in the NAFTA negotiations.  

As if this was not enough to prompt caution in the markets, president Trump is also due to meet North Korea's Kim Jong-un on Tuesday, having travelled to Singapore on Saturday after leaving the G7 early.  Given the president's erratic mood, his positive outlook on the talks will and should be taken with a pinch of salt.  

FX market reaction

Currency markets have started the week as if there is little risk to contend with, and there are clear events ahead which traders seem more interest in positioning for.  

Starting off with the euro (EUR), we once again see the market looking for ECB communication on signalling and end to QE.  Comments from governing council members have alluded to as much, but with inflation picking up aggressively, we expect their primary mandate of asset price stability to firm up their forward guidance, and especially so as they have played down the slowing in the pace of growth and expansion at the start of the year.  

Pricing for rate normalisation next year has tightened up to see the Deposit rate back to flat by the end of next year, and this could help arrest some of the near term weakness in the EUR, but Italian political confidence will be eating away at sentiment in the background. 

Comments of the weekend from new government Econ Min Tria that Italy does not intend on leaving the EUR were not entirely convincing, as he also said that the government will do everything they can to avoid market conditions which would lead to an exit “materialising”.  Reading between the lines, there is a clear warning there.  

What makes the ECB meeting and the market response more interesting this week is that it will come straight off the back of the FOMC announcement on Wednesday night when the Federal Reserve are widely expected to raise the 'funds' rate by another 25bps.  

It is fair to say that this is entirely priced in - priced in aggressively, in fact, in the strong dollar (USD) turnaround seen in the last two months – and, as such, the accompanying statement on growth, inflation and rate path will be all the more influential.  

There is, as a result, the likelihood of a USD pullback in spite of higher rates in the US and we have already seen the greenback failing to extend on recent gains despite a series of strong data.  

US non-farm payrolls was the first instance of the USD showing signs of tiredness on the upside, and with both the ISM manufacturing and non-manufacturing PMIs coming in strong, we still saw the USD struggling to continue the recovery which took hold so firmly through April and May.  Too fast too soon.  

This is pretty much the verdict of all currency watchers, with EUR/USD having turned face sharply.  Tipping 1.2500 at the start of the year - and a number of time at that - it then tested 1.1500 just two weeks ago, so pure market dynamics have finally kicked in.  

Whether ECB developments will be enough to start off a material EUR/USD recovery is in the balance at this point, but technically there is room for a move towards 1.2000, even 1.2100 before the market will call time on the downside. 

Past performance is not a guide to future performance

For USD/JPY, pure rates-based factors are prompting dip buyers at present, and we have seen this first thing on Monday with the lead rate racing back to 110.00 as traders do not want to get on the wrong side of the FOMC decision on Wednesday.  

Risk factors cannot be ignored at this point and, as mentioned above, there are potential headwinds in the US trade relationship with Japan if the president presses ahead with plans to tax foreign cars.  

The Bank of Japan (BoJ) also meets this week, but its intentions are well versed in public comments on maintaining powerful easing measures, so it is unlikely they would unsettle the market, and more importantly Japanese yen (JPY) levels, which are critical to maintain export volumes in the current global environment.  

The US 10yr Note is still well placed to push back above 3.00% again, and is more likely to do so if the Fed sticks to three hikes this year.  Pushing too hard in the near term will revive fears that the next economic downturn will come sooner than priced in, and we will again get curve steepening which could be pivotal for equity markets. 

Past performance is not a guide to future performance

US yields also have to contend with the week's US inflation report which is due out on Tuesday.  The CPI data covers May when energy prices had a volatile month.  WTI hit highs above $72 and then fell towards but a little shy of $65, but also in that time, the USD rally was in full swing, so there are risks to the downside here.

However, consensus expectations are for a rise from 2.5% to 2.8% while the core is seen edging up to 2.2%. The Fed has been pretty clear and relaxed in tolerating and inflation overshoot, with few if any of the members expecting such a development to be sustained. 

Even so, ahead of the Fed announcement on Wednesday night, these numbers could prompt some volatility in the rates and currency markets. 

Retail sales and manufacturing data later in the week should elicit some more measured responses with the Fed outlook still be digested, but will help determine whether the USD revival has further legs as some are still looking to based on economic considerations alone.  

Outside of the ECB decision, Friday's May inflation number will be another focal point for markets, but, once again, volatility could be suppressed if the governing council finally confirm what many have been expecting in an end to QE this year (with or without tapering).  

It is also a very busy week in the UK, with the data schedule choc-a-bloc.  Starting off on Monday, we saw Apr production numbers coming in very weak.  Manufacturing fell 1.4% vs a 0.3% rise anticipated, but if we look back to the PMIs for May, there are signs of hope on a modest turnaround.  

Widening trade deficits for Apr also added to worrying signs on the economy, where the bank of England (BoE) is looking for a rebound in Q2 to offset the surprising level of weakness seen in Q1.  

Rate pricing has moved towards an August hike at the earliest, but there look to be plenty of reasons for holding off again, with some pundits calling for the BoE to sit on their hands for the rest of the year. 

Brexit negotiations have also deteriorated, not least of all due to disunity within the Tory ranks.  Parliament is split on the issue of the customs union which, if it went the way of the Remain-friendly MPs, would resolve the Irish border conundrum. The latest backstop proposal issued last week had cold water poured over it by the EU's chief negotiator Barnier, who pointed out that a time limit was effectively unacceptable.  

Ominously, he also said the backstop could not be extended to the whole of the UK, which some will view as a cynical move to divide the already fragile government held together with the help of the DUP.  UK MPs - Brexiteers - picked up on this last week.

Past performance is not a guide to future performance

Votes on the Withdrawal Bill will be conducted over Tuesday and Wednesday, and PM May will be fighting tooth and nail to get the necessary backing to quell the rise in Tory rebels, who could side with Labour on customs and EU alignment, and again undermine the government position going into the talks with the EU.  

Away from politics, the UK jobs report is out on Tuesday morning, and 24 hours later we get the latest inflation stats, which are less relevant now that headline CPI is seeing the exchange rate effect passing through.  

CPI levels are now more significant in conjunction with wage growth levels, with the market looking for yearly earning to maintain 2.9% growth.  On Thursday we get retail sales, after Apr saw a strong rebound of 1.6% - a more modest 0.5% rise is expected for May.  

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