There's More Trouble Ahead for the Dollar & USD/JPY

The single most important theme in the financial markets this past week was risk aversion. The Dow Jones Industrial Average experienced its largest one day decline in 3 months while the VIX, which measures the volatility in the equity market rose to its highest level since April.  Although many currency pairs ended the week not far from where they started, the lack of major changes masks sharp mid week reversals.  The Swiss Franc was the best performer, confirming that uncertainty drove the move in currencies.  While the U.S. dollar nose dived against the Japanese Yen after almost hitting 111 it ended the week higher versus euro and sterling.  The Australian, New Zealand and Canadian dollar managed to hold up pretty well but all 3 could be vulnerable to risk aversion if U.S. stocks sell-off in the coming week.

Looking ahead the big question now is whether the market's attitude can be changed by the Federal Reserve Summit at Jackson Hole August 24 to August 26.  For many people, this past week's stronger than expected retail sales report has become a distant memory but it shouldn't be because not only did consumer spending double expectations, but the initial declines reported in June and May were revised higher. So instead of falling, spending actually steadied or increased which supports the Fed's case of an improving economy.  The Empire State and Philadelphia Fed manufacturing indices also beat expectations as consumer confidence rose to its highest level since January according to the University of Michigan report.  Fed President Dudley who is a voting member of the FOMC and one of the main architects of the central bank policy expressed his confidence in the economy confirming that next month, the Fed will begin reducing its balance sheet.  Dudley backs another rate hike before year end, sees growth near 2%, thinks the job market will tighten further and feels that so far the Fed has been very very gentle in removing accommodation.  This general sentiment about the need to unwind the balance sheet in September is echoed by nearly every U.S. policymaker who has spoken this month and we believe this message will ring loud and clear at Jackson Hole next week.  But first, the U.S. and South Korea are scheduled to hold military games on Monday, if they move forward and reignites North Korea's fire, USD/JPY will extend its losses towards 108.00.  As the week progresses though, USD/JPY could recover as investors look for positive comments from Jackson Hole.

Yet as we've seen this past week, positive data and monetary policy developments can only take the dollar so far in a deteriorating political environment. At the start of the week, investors were relieved that tensions between the U.S. and North Korea eased but the protests and clashes in Charlottesville spiraled out of control. President Trump's response to the conflicts created a leadership crisis that cost him the support of key business leaders who resigned from the President's business councils, forcing him to disband the panels altogether.  Prominent Republican leaders also spoke out against Trump leaving investors worried that the more he does to isolate himself from business, military and political leaders, the harder it will be to push forward his economic agenda.  After taking U.S. stocks to record highs, investors are finally losing confidence in the Trump Administration's ability to focus on tax reform when they are so regularly distracted by the President's unpredictable responses to major political tests.  Looking ahead, U.S. - North Korea relations and Trump's relationship with fellow Republicans will be just as important to the dollar as Jackson Hole. There are no major U.S. economic reports scheduled for release next week - durable goods, new and existing home sales are the only items worth watching on the calendar. 

Between the ECB's views on the currency, the terrorist attack in Spain and arrests in Finland, EUR/USD should be trading below 1.17. The tragedy in Barcelona is a harsh reminder of the ongoing geopolitical risks facing the region.  From an economic perspective, these attacks increase allocations to anti-terrorism efforts, discourage tourism and deter consumers from frequenting restaurants and other establishments.  So far we haven't seen a major impact but if they continue, we could.  The only reason for the euro's resilience is U.S. dollar weakness but if risk aversion exacerbates, we could see a more material decline in the currency. The most significant developments this past week in the Eurozone aside from Barcelona were the ECB's comments on the currency. After a 13% rally in EUR/USD year to date, the central bank is finally expressing concerns over the currency's gains.  In the account of their last monetary policy meeting, they worried about the risk of the euro overshooting and the impact that it would have on inflation.  They saw conclusive evidence of inflation pick up lacking but also attributed part of the euro's gains to improving conditions in the Eurozone economy.  There's no question that the economy is doing better with the trade surplus rising to 22.3B from 19.0B but the longer the euro remains elevated, the greater strain it puts on external demand and economic data.  ECB President Mario Draghi will be speaking at Jackson Hole next week and it is unclear whether he will use this platform to prepare the market for tapering.  Some analysts believe he plans reserve the big announcement for his home turf but with only 2 weeks between Jackson Hole and the ECB meeting, suggesting that they could reduce asset purchases would give investors more time to discount the move.  Eurozone data will also be focus with August PMIs, the German ZEW survey and IFO reports scheduled for release. Looking ahead, we continue to look for EUR/USD to break below 1.17. 

This past week was an important one for sterling and while there were both positive and negative economic reports, there's no question that the latest round of U.K. data supports the case for slower monetary policy removal. Consumer prices declined in the month of July, leaving the year over year growth rate at 2.6%.  However labor market conditions improved last month with wage growth accelerating and consumer spending rising but these reports did not have a lasting impact on the currency because the uptick in spending was offset by a sharp downward revision in June.  These reports paint a picture of uneven growth and when taking the Bank of England's recent downgrades into consideration, there's evidence that the central bank is in no rush to normalize monetary policy. For this reason, we would not be surprised to see sterling extend its losses particularly against the U.S. dollar and Japanese Yen. 

All three of the commodity currencies, the Australian, New Zealand and Canadian dollars ended the week higher than where they started.  A large part of that had to do with the recovery in commodity prices and the sell-off in the U.S. dollar but domestic data also played a role in the strength of these currencies.  For Australia, labor market conditions remain healthy with job growth rising in the month of July. Although full time growth declined (after 2 strong months of larger than average increases), the unemployment rate dropped and average hourly earnings increased. The RBA may not be happy with the level of the currency but unless data shows weakening activity, the lack of demand for U.S. dollars could overshadow the market's outlook for the economy and Australia's political troubles.  AUD/USD found its way back above the 20-day SMA and if we see another move above 0.7950, 80 cents comes back into sight.  With no major Australian economic reports scheduled for release next week, the outlook for AUD/USD hinges on the performance of the U.S. dollar.  In many ways, the same is true for the New Zealand dollar although there have been some bright spots in New Zealand's economy.  While dairy prices declined and service sector activity slowed, consumer confidence increased and producer prices did not follow CPI lower. In the week ahead New Zealand's pre-election economic and fiscal outlook is scheduled for release along with the country's trade balance report.  A continued rise in annualized CPI growth drove USD/CAD back below 1.26.  The Bank of Canada is one of the most hawkish central banks and this latest report confirms the need for another rate hike. If Tuesday's Canadian retail sales report shows that consumer demand is healthy, we could see USD/CAD break 1.25.