We had three major central bank meetings this past week, and all of them moved to tighten: the Bank of England raised rates and the Fed signaled it’s on course to do so. This continues the gradual withdrawal of stimulus that we’ve been seeing in the last few months. The graph shows that as recently as February, the major central banks’ balance sheets were growing 16% yoy. That’s slowed to about 3% yoy now, and looks likely to slow further. While so far only the Fed is actually shrinking its balance sheet, the ECB and Bank of England will start to do so eventually. This reversal in the growth of global liquidity is going to present a lot of problems for various asset classes, particularly in emerging markets.
The Bank of Japan seems to be the outlier. If anything, it strengthened its easing bias by reaffirming its forward guidance, saying in an echo of the ECB that it “intends to maintain the current extremely low levels of short- and long-term interest rates for an extended period of time.” On the other hand, it also allowed the 10-year Japanese government bond yield a bit more freedom to move around (a range of ±20 bps around zero looks likely, vs ±10 bps before). You can see from the graph how although 10-year yields had remained within that band since the inauguration of the “yield curve control” policy in September 2016, yields jumped out of that range immediately upon the announcement Wednesday. That too is in essence a form of tightening, albeit a modest one at best.
The impact of this tightening could mean less USD appreciation going forward. The graphs below show that in general, the Fed’s shrinking of its balance sheet relative to the ECB, BoJ and BoE has been one of the factors driving the dollar’s appreciation. But from now, as the ECB and BoE begin to shrink their balance sheets, the pace of relative change is likely to slow, meaning less upward pressure on the dollar. This trend may leave JPY vulnerable however as it continues to expand its balance sheet, at least modestly.
Certainly the fact that the pound fell vs USD even though it raised rates indicates underlying pessimism towards sterling. It’s a classic “buy the rumor, sell the fact” response as the market had been solidly discounting a rate hike. Now with that out of the way and no more rate hikes on the horizon, the market can go back to worrying about Brexit, the gift that never stops giving to GBP bears. It looks more and more like Britain will crash out of the EU without any plans in place – the disaster scenario for the country and for GBP.
CAD was the only major currency to gain on USD over the last week. This was clearly because of hopes of an early resolution to the NAFTA talks about cars, which are about to start. You can see how USD/CAD tracked USD/MXN, indicating that both currencies were trading off the same news.
Although Canada is being left out of the auto talks, the result would probably apply to them too. Cars are a major export for the two countries, amounting to some $82bn a year for Canada and $109bn for Mexico. An early resolution of this issue would be extremely beneficial for both countries. Personally I doubt if they will in fact reach agreement on this difficult issue any time soon and I would rather be a buyer of USD/CAD.
As for the coming week, much will be determined Friday afternoon when the US nonfarm payrolls (NFP) come out. As usual nowadays, the average hourly earnings (AHE) figure is actually more important than the payrolls in determining the subsequent movement of the market. The graph below shows that an hour after the release of the figures, the movement in EUR/USD has virtually no correlation with the surprise in the NFP figure but is correlated somewhat with the surprise in the AHE figure. More sophisticated econometric analysis shows this to be the case – the AHE figure is more important. In that case, with a relatively strong 0.3% AHE figure forecast, we could be in for some further dollar strength.
The effect doesn’t always last, however. As these graphs show, a week later EUR/USD was higher (i.e., USD was weaker) three out of the last six times there was a positive surprise and only lower twice. On average (red line) it was unchanged.
EUR/USD was also higher four out of the last six times there was a negative surprise.
My conclusion is that basically, the NFP and associated data make for a flurry of activity on Friday but generally do not change the trend the following week unless they are a significant surprise one way or the other.
As for next week, it’s likely to be relatively quiet, as the second week of the month typically doesn’t have that much on the schedule.
The Reserve Bank of Australia (RBA) meets on Tuesday and the Reserve Bank of New Zealand (RBNZ) meets Thursday (New Zealand time). Neither bank is expected to make any changes in policy for the foreseeable future; the market doesn’t see a rate hike as being likely in Australia until August next year, while the odds for a rate hike this year in New Zealand are zero.
As you can see, the daily range on days when the RBA meets are usually no different nowadays than the average range on other days, because nobody really expects any major change from them. And the range is less than normal for the RBNZ, perhaps because people hold off trading ahead of the meeting and then get no real impetus to trade afterwards. I don’t expect much in the way of fireworks this time, either.
The key indicator out during the week will be Friday’s US CPI for July. It’s expected to show headline inflation rising 3.0% yoy, which is well above the Fed’s 2% target and enough to ring some alarm bells, I would’ve thought. Core inflation is forecast to remain the same at 2.3% yoy, however. Even though this is not the figure the FOMC officially uses to gauge inflation – that’s the personal consumption expenditure deflator – it’s what most people think of as the inflation rate and is therefore still the key number for the market. I think this figure should be positive for the dollar.
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