By Kathy Lien, Managing Director of FX Strategy for BK Asset Management.
It has been a week of good news in the financial markets and the record-breaking levels in U.S. stocks tell us that investors are pleased with the recent developments. Particularly the fact that the U.S. reached a trade deal with Mexico, talks with Canada are going well and the EU is willing to work with the UK. It remains to be seen whether these talks will turn into paper agreements but the hope that it will is enough to drive currencies and equities sharply higher. As long as the positive headlines continue to flow, the risk rally should continue. USD/JPY is finally participating in the move thanks to a stronger Q2 GDP report. Economists were looking for growth to be revised lower but instead it went up to 4.2% from 4.1%. Thursday’s personal income and spending reports should also be stronger as earnings and retail sales increased last month.
Sterling was the best performer Wednesday gaining more than 1% against all of the major currencies. According to the European Union’s Chief Brexit negotiator Barnier, the EU is ready to offer the UK a deal that it hasn’t had with any other country. Coming hours after Brexit Secretary Dominic Raab complained about his availability for talks, the possibility of an unprecedented offer sent sterling sharply higher. GBP/USD broke out of a 5-day long consolidation to trade above 1.30 while EUR/GBP experienced its strongest one-day decline in more than 2 months. Raab is heading back to Brussels on Friday to resume negotiations with the goal of reaching an agreement by November. This type of news is exactly what sterling traders have been waiting for. Although a deal still hasn’t been made, the EU’s willingness to cooperate should be enough to take GBP even higher. Speculators are aggressively short sterling and Wednesday’s breakout will motivate traders to cover their shorts. We see GBP/USD rising to at least 1.3050 and possibly even 1.32 on short covering flows alone.
On Tuesday we were looking for the euro to pull back and it came off its highs to hit a low of 1.1650. But with all of the good news, EUR/USD found itself back at 1.17. The rally occurred despite weaker German consumer confidence and softer French consumer spending. There was talk that Italy may ask the European Central Bank to fund a new round of bond purchases but not only would this be politically difficult for the central bank but Deputy Prime Minister Luigi Di Maio also denied the report. He said “we are not asking for any help from anyone” and if that’s true, then the decline in Italian bond yields Wednesday was unjustified. The euro is a particularly attractive sell versus sterling because the ongoing appetite for risk should have a greater impact on EUR than GBP. We think that at minimum, EUR/GBP will drop to .8950.
USD/CAD ended the day unchanged but it should be trading lower after Wednesday’s positive comments from Canada. The talks must be going well because early this morning, the White House’s Council of Economic Advisers Chairman Kevin Hassett said a lot of progress is being made in trade talks with Canada. Later on, Prime Minister Trudeau said there could be a NAFTA deal by Friday. USD/CAD hasn’t moved because traders are skeptical but Canada doesn’t have much choice because the deal between the US and Mexico threatens the supply chains that Canada has built across the continent. A trilateral agreement is absolutely necessary for all parties involved because as Treasury Secretary Mnuchin said this week, the U.S. and Canadian markets are very intertwined. Predicting the emotional component of the trade talks (re: President Trump) is difficult but all signs point to an agreement this week. When the announcement is made, USD/CAD could drop to 1.2850 but we expect to see a move toward that level in the next 24 hours.
One of the worst-performing currencies Wednesday was the Australian dollar. The currency fell sharply for two important reasons. First, Westpac raised its variable mortgage rates by 14bp. This makes home payments more expensive, which reduces disposable incomes and hurts spending. It also takes away the RBA’s choice to raise interest rates. Its recent outlook has been positive but it has no plans to tighten and if higher mortgage rates start to curb growth, RBA may have to start thinking about easing. And what’s worse is that more banks could follow in Westpac’s footsteps. The Chinese yuan is lower as well, adding pressure on the Australian dollar. Private capital expenditures and building approvals were due Wednesday evening. The New Zealand dollar rallied alongside EUR and GBP. NZ building permits and ANZ business confidence numbers were also scheduled for release Wednesday evening.