Forex: Week Ends with Ongoing Deutsche and OPEC Uncertainty

This past week was suppose to be a quiet one in the foreign exchange market but between OPEC's decision to cut oil production for the first time in 8 years and the brewing banking crisis in Europe, we've seen a sharp increase in volatility across the financial markets. U.S. stocks traded lower as risk aversion permeated the equity and currency markets. Investors practically forgot about the Federal Reserve's potential rate hike at the end of the year and discounted the significance of stronger consumer confidence, service sector activity, durable goods, trade and GDP data.  These reports strengthen the case for a December rate hike even as personal income and spending growth slows but if Europe's banking troubles escalate the strain that it has on the financial markets may make it difficult for the Federal Reserve to pull the trigger on raising rates.

 

With that in mind, a U.S. rate hike will still be a focal point next week with ISMs and non-farm payrolls scheduled for release.  Stronger manufacturing and service sector activity along with a solid jobs report could get investors excited about a year end rate hike but the amount of job growth and pace of wage gains would need to be very good.  We heard from a number of U.S. policymakers over the past week and there was clear hesitancy in most of their voices.  The U.S. economy may be improving and jobs are growing but inflation and productivity is still too low and unless there are improvements over the next 3 months, a number of policymakers could vote against raising rates especially if Deutsche Bank's troubles turn into a full fledged crisis for the region.

 

As for the U.S. dollar, risk aversion should keep the greenback bid against high beta currencies like the euro, British pound, Australian and New Zealand dollars. We don't expect significant gains in USD/JPY or USD/CHF because these pairs usually fall when stocks decline and investors won't be eager about buying these currencies ahead of Friday non-farm payrolls. Buyers should sweep into USD/JPY near 100 with sellers coming in near 102 pre-NFP.  Japan's Quarterly Tankan report is also scheduled for release and while economists are calling for stronger business confidence we think confidence could weaken in light of yen strength and weaker consumption.

 

Commodity currencies will be in play next week with the Reserve Bank of Australia's monetary policy announcement and Canada's employment report scheduled for release. On Friday we learned that Canadian GDP growth accelerated more than expected in the month of July. The improvement was driven largely by trade activity because retail sales declined. This report should have no impact on next week's trade and labor market data. Canada reported strong job growth in August with a particularly healthy increase in full time work so we would not be surprised by some payback in September.  Canada's employment and IVEY PMI report are not scheduled for release until Friday which means that oil will continue to have a significant impact on the currency. While OPEC's decision to cut production is a significant one, some investors expressed skepticism about the actual execution and the subsequent effect the deal would have on the supply. The issue at hand is that output levels have not been strictly defined for OPEC countries. Even when the levels are defined, the effectiveness of OPEC comes into question. The lack of detail has many investors worried that the deal could break down between now and November.  So while we are bullish the Canadian dollar, we prefer selling USD/CAD at the top of its range rather than the bottom.

 

The Reserve Bank of Australia has a lot to think about when they meet on Tuesday.  The last time they convened they expressed confidence in the trend of growth and labor market.  Their neutral bias was a breath of fresh air compared to the dovish sentiment expressed by the Reserve Bank of New Zealand and the Bank of England.  The country's PMI manufacturing report will be released ahead of the meeting and the outcome could shape monetary policy expectations. While the RBA is not expected to change interest rates, adjustments to their outlook could have a meaningful impact on the currency. There are no major economic reports scheduled for release from New Zealand.  The Treasury is expected to publish its monthly economic indicators but the impact on NZD should be limited.

 

Meanwhile the euro has been surprisingly resilient in the face of Deutsche Bank's troubles.  It dropped to a low of 1.1150 but not much more beyond that. The biggest story in the financial markets this week is the growing fear that DB will become the next Lehman Brothers. Clients are withdrawing excess cash, lowering collateral on trades and generally cutting exposure to the bank. The euro should be trading much lower but it is holding up very well in light of the risks. If this were truly a Lehman moment for Europe, EUR/USD would be at 1.10 and not 1.12.  We see only two explanations for the currency's resilience - German yields are up and U.S. yields are falling or the majority of investors still believe that Deutsche Bank is too big to fail. The only way to stop this crisis of confidence is for Chancellor Merkel to offer a bailout but next year is an election year and this could be political suicide. Merkel has been a vocal about not putting taxpayers on the hook for bank bailouts but at some point, the economic consequences could outweigh the political fallout. If the region's banking troubles escalate, 1.10 will be an easy target for EUR/USD.  

 

Last but not least, sterling remained under pressure throughout the week. There weren't any major economic reports released and no new Brexit headlines but Bank of England member Shafik reminded investors that rates might need to fall further. The case for a rate cut will become clearer in the coming week with the U.K.'s PMI reports scheduled for release.  If manufacturing and service sector activity slow, GBP/USD could drop to support at the August low of 1.2866. If the numbers are good, the currency could rise to the 50-day SMA near 1.3130. Also Deutsche Bank's troubles raises concerns about other banks in Europe as Credit Suisse and Barclays are also in mortgage settlement talks with the U.S. government. Should Barclays fall into a similar crisis of confidence, the Bank of England will step up its calls to ease.