By Kathy Lien, Managing Director of FX Strategy for BK Asset Management.
Between North Korea's decision to scrap its missile tests near the waters of Guam and overwhelmingly positive U.S. data, the U.S. dollar should have traded sharply higher. It has been a strong day, but to the surprise of many, the rally fizzled shortly after U.S. markets opened for trading. Retail sales rose 0.6% in July, which was 2 times stronger than expected and a significant improvement from the past month's levels. Retail sales ex autos and gas also rose 0.5% versus a forecast of 0.4% but most importantly spending in June was revised up from -0.2% to 0.3%. In other words, instead of contracting, spending actually increased 2 out of the last 3 months. Manufacturing activity also expanded strongly in the NY region with the Empire State survey rising to 25.2 from 9.8, to the highest level since September 2014. These reports should have driven USD/JPY to 111 but instead after reaching a high of 110.85 the pair nosedived ending the NY session near 110.50.
There were a few problems: first, the market does not truly believe the U.S. North Korea showdown is over. Kim took the first step and threw the ball into Trump's court and the president responded by retweeting a Fox & Friends headline citing Secretary Mattis as saying, "If North Korea fires missiles at U.S., its "game on." Second, despite stronger economic reports, rate-hike expectations barely changed as the odds of a December move increased to only 43.8% from 40.6%. The thought is that one good spending report won't change the Fed's mind about tightening with inflation moving in the wrong direction. On this, we have to point out that retail sales in May and June were revised higher so there was actually no consumption contraction over the past 3 months. Demand in the second quarter outpaced the first and the third quarter is off to a strong start. All of it should have been a lot more positive for the greenback than it ended up being as the data was much stronger than the headline suggests. Nonetheless, 10-year Treasury yields found resistance at 2.3% and the retracement was the third reason why the dollar retreated. With the FOMC minutes scheduled for release Wednesday, we expect USD/JPY to hold onto its gains and stay above 110.
Next to the Japanese yen, sterling was hit the hardest. This is a big week for the British pound and it starts with consumer prices falling -0.1% in July. The dip kept the year-over-year rate steady at 2.6%, which is still well above the central bank's 2% target. Labor data is due for release Wednesday and we expect claimant count to fall. According to the PMIs, employment in the service sector grew at its fastest pace since January 2016 and in the manufacturing sector job growth was the strongest in 3 years. The focus however will be on wage growth, which decelerated last month. In its Quarterly Inflation Report, the Bank of England also revised down its wage-growth forecast, suggesting it sees little to no sign of recovery. If wage growth continues to slow, the next level GBP/USD will test is 1.2800.
While euro also traded lower against the U.S. dollar, its losses were less than many other major currencies and it recovered the quickest after the initial post data drop. Some changes were made to second-quarter German GDP growth and that included slightly firmer annualized growth. With members of the Bundesbank talking about the strength of the Eurozone recovery, we continue to look for the euro to outperform other currencies leading up to ECB President Draghi's speech at Jackson Hole next week. Eurozone GDP numbers are scheduled for release Wednesday and we don't expect the report to pose much threat to the currency.
All 3 of the commodity currencies extended their losses against the greenback. The biggest loser was the New Zealand dollar, which was pressured by lower dairy prices. A big rebound was anticipated but instead of rising, dairy prices fell -0.4%, the fourth decline out of five. Between the RBNZ's intervention talk, softer data and Tuesday's drop in dairy prices, NZD should be headed for further losses. Although AUD/USD also fell, it was not because of the RBA minutes as the currency actually popped higher on the report. The central bank expressed concerns about consumption but also expressed optimism about growth. USD/CAD hit a 1-month high despite stronger housing data and higher yields. The move was driven entirely by oil prices, which rebounded from their lows and the rally in the U.S. dollar. NAFTA discussions continue on Wednesday so watch for these headlines to affect the Canadian dollar and oil.