USD - Tax Reform vs. Russia Probe, What Matters More?

The last month of the year kicked off with a bang. Currencies, equities and Treasuries were hit by major intraday volatility that resulted in a rollercoaster ride for all investors on Friday. The moves in the forex market were led entirely by the wild swings in the U.S. dollar, which see-sawed with every incoming news headline. Investors tried to decipher the ramifications of each story quickly, but as the dust settled it is still not clear whether the prospect of tax reform or the threat of President Trump being indicated for obstruction of justice will have greater long-term impact on the markets. The dollar ended the week lower against the British Pound, Swiss Franc and Canadian dollars and higher versus the Japanese Yen and New Zealand dollar. It was virtually unchanged against the euro and Australian dollar.  Although these moves are not consistent, on balance the U.S. dollar performed well in the front of the week and suffered greatly towards the end. These divergences stemmed from the relative outperformance of these currencies versus the dollar on Friday. For example, AUD and NZD soared while EUR and GBP barely saw gains. 

There's no doubt that this was a week where politics completely overshadowed economics. Tax reform is the main focus and on early Friday when it became increasingly clear that the tax bill would pass the Senate, USD/JPY hit a high of 112.87. Some Republican Senators held out to the very last minute but the GOP's motivation and last minute negotiations/concessions means a deal could be announced hours after we go to press.  Unfortunately investors were unable to celebrate because they were distracted by Michael Flynn's guilty plea and reports that he would say President Trump directed him to contact the Russians.  They are worried about Trump being charged with obstruction of justice or impeachment, which still seems a long way away but there's no doubt that this is all bad news for Trump especially during a time when he wants the market and Americans to focus on his tax reform success. Even if there's evidence that Trump obstructed justice, it is unclear whether he will actually be prosecuted.  During Watergate, the Justice Department ruled that indicting a sitting president would "undermine the capacity of the executive branch to perform its constitutionally assigned functions." Impeachment with a Republican controlled Congress in an election year would be an even greater challenge.

So unless we are battered with fresh headlines related to the Russia probe next week, the main focus for the dollar will be reconciliation of the House and Senate bill along with the prospect of a December rate hike and the November non-farm payrolls report.  We'll also be watching North Korea headlines - they said they are ready for nuclear war with the U.S. but are also willing to talk if Russia participates as a guarantor state.  At the end of the day, we expect some follow through selling of dollars early next week with a potential recovery the second half of the week on the hope for a good jobs report. Non-farm payrolls are expected to rise by nearly 200K, which is a good number even if it is lower than the previous month but the key will be wage growth, which is expected to rebound after stagnating in November.  The market is still pricing in a 96% chance of a hike on December 13th but they are divided on the timing of the next hike. 

Of all the major currency pairs, EUR/USD had the narrowest trading range this past week.  Price action was limited to a low of 1.1809 and a high of 1.1961.  German Chancellor Angela Merkel is struggling to form a coalition government and while there are reports that she is in talks with the Social Democrats to form a grand coalition, the leader of the SPD party denied the negotiations.  The country's political trouble is the main reason why the euro failed to benefit from the dollar's slide on Friday.  The latest economic reports from the region were mostly healthy with inflation rising in November, German jobless claims falling, Eurozone confidence increasing and the unemployment rate slipping to 8.8% from 8.9%. While many of these reports fell short of expectations, they improved from the previous month.  The only bad news were German retail sales which plunged in October but investors ignored the report.  Looking ahead, the performance of the euro will still be driven by German political news and the direction of the U.S. dollar as German industrial production and trade balance are the most important pieces of data on the Eurozone calendar.  For the time being, EUR/USD appears supported above 1.1800.

In a matter of 3 weeks, GBP/USD soared more than 400 pips as the prospects for a EU-Brexit deal brighten. However nothing has been confirmed by the U.K. government or the European Union and most headlines suggest that the Irish border and the Brexit bill remain key stumbling blocks.  Nonetheless, with many papers reporting that an agreement on a Brexit payment is close, investors are hopeful that the talks, which have been frozen for months are slowly unlocking.  With the EU Summit coming up on December 14th, Prime Minister May is expected to put everything she has into advancing the talks.  Next week, May heads to Brussels to meet with Jean-Claude Juncker and this is her first opportunity to provide the U.K.'s divorce bill offer and to talk about their plans for the Irish border.  Then on December 6th, EU ambassadors resume preparations for the summit.  While UK PMI services, trade and industrial production numbers are scheduled for release, Brexit headlines should continue to drive sterling's flows.   

Next week is also an important one for the Australian and Canadian dollars with monetary policy announcements scheduled for the Reserve Bank of Australia and the Bank of Canada. No changes are expected from either central bank but the recent increase in volatility means AUD and CAD could have a larger than usual reaction to their central bank's outlooks. Starting with Australia, there have been fewer than usual economic reports released between monetary policy announcements. For example, retail sales, the trade balance and Q3 GDP won't be shared until the day of or after the RBA rate decision.  Since the last meeting in November, consumer confidence has fallen, inflation expectations declined and housing activity slowed. Labor market indicators were mixed but for the most part the RBA is happy with the jobs market.  Business confidence and manufacturing activity also improved as iron ore prices rocketed higher. These improvements will encourage the RBA to maintain their neutral policy stance while preserving their view that inflation will remain low for some time. Since we don't expect anything new from the central bank, the impact on AUD should be limited. Instead the currency may have a greater response to next week's retail sales and GDP numbers.  We continue to believe that AUD/USD has found a near term bottom above 75 cents.  In contrast the outlook for New Zealand is not as bright with reports of weaker building permits, business confidence and terms of trade.  NZD should be trading much lower but the currency is deeply oversold and the sellers are just not emerging. There are no major economic reports on next week's calendar so anyone trading the New Zealand dollar should be watching Tuesday's dairy auction.  China's November trade balance report could also impact both currencies.

For the Canadian dollar, all of the past week's losses were recovered in one day on Friday on the back stronger than expected GDP and employment numbers.  It was the best day for the loonie in more than 8 months and a large part of that has to do with how these reports will impact the Bank of Canada's economic assessment next week.  With more than 79K jobs added in the month of November, Canada experienced the strongest period of job growth in 4 years. Full time and part time work increased, driving the unemployment rate to its lowest level to its lowest level since February 2008.  While GDP growth slowed in the third quarter, the robustness of the labor market and stronger than expected GDP growth in September completely overshadowed the report.  The Bank of Canada has less to worry about in December than in October because everything from retail sales, to the labor market, housing market, manufacturing activity, trade and oil prices improved since the last meeting. The only area that deteriorated was inflation.  While that is also a big focus for the BoC, we expect USD/CAD to trade lower into and possibly following the rate decision.