By Kathy Lien, Managing Director of FX Strategy for BK Asset Management.
Investors sent EUR/USD to its highest level this month on the back of the European Central Bank’s monetary policy announcement. Considering that euro was trading strongly ahead of the rate decision, it didn’t take much for the currency pair to hit 1.17 and now that it has, many traders are wondering if they should fade or follow the move.
To answer this question, we need to dissect Super Mario’s latest outlook – judging from his comments, we know he’s worried about growth (hence the lowered GDP forecasts for 2018 and 2019), protectionism, emerging-market turmoil and external demand. Yet EUR/USD rallied because low inflation has become less of a concern. According to Mario Draghi, domestic cost pressures are strengthening and inflation should pick up toward the end of the year and rise gradually in the medium term. The central-bank Governor’s concerns about trade tensions are also tempered by his view that global demand is strong. Despite the GDP downgrades, a healthy labor market keeps their economic outlook broadly balanced.
Market sentiment and positioning is very important when it comes to trading major event risks. Had the euro been hovering near this month’s low ahead of the rate decision, traders would have latched on to the central bank’s lower economic projections. However, the possibility of a GDP downgrade was leaked on Wednesday, giving investors the opportunity to discount the central bank’s move. The recent decline in Italian bond yields also helped euro stabilize this week. So when the softer US consumer price Index was released, EUR/USD popped higher and extended its gains to 1.1700. Traders, who were looking for a reason to cover their shorts, focused on the positive elements of Draghi’s comments. They were happy that he had anything positive to say at all and relieved there was no mention of the data disappointments in Germany and Italy.
On a technical basis, the pair broke out of an 8-day long consolidation but Thursday’s rally stopped right at the 100-day and 20-week SMAs, which are natural areas of resistance. Shorter-term charts show the possibility of continued gains but that’s predicated on Friday’s U.S. retail sales report. Producer and consumer prices surprised to the downside this week with year-over-year US CPI growth slowing to its weakest pace in 4 months. While neither one of these reports will stop the Federal Reserve from tightening this month, they increase the chance that it’ll be the last hike of the year. If retail sales also surprises to the downside like economists anticipate, it would reinforce the EUR/USD’s positive bias and take the pair to 1.18. However if consumer spending improves – and we think it could given the acceleration in wage growth – the record-breaking moves in U.S. stocks and stronger spending reported by Johnson Redbook, EUR/USD could sink back down to support near 1.1610.
Sterling also traded higher on Thursday but not as a result of the Bank of England’s monetary policy announcement. GBP/USD actually weakened slightly after the central bank voted unanimously to leave interest rates unchanged. Its decision wasn’t a surprise considering that BoE just raised interest rates in August. The central bank expects inflation to ease next year due to an energy price cap but pay could be stronger due to a healthy labor market. Ongoing tightening will be needed according to the central bank but future rate hikes will be limited and gradual. It wasn’t until the release of U.S. CPI that GBP/USD started to strengthen. The pair eventually broke above 1.31 on the back of the ECB’s optimism and general USD weakness. Looking ahead, Brexit negotiations continue to go well and we think that they will carry GBP/USD to 1.32.
The Australian and New Zealand dollars stretched higher while the Canadian dollar held back. AUD and NZD benefitted from the general improvement in risk appetite and Wednesday night’s stronger-than-expected labor-market report. A total of 44K jobs were created in August, the majority of which were full time. The Australian economy has held up remarkably well despite slower Chinese growth and China’s troubles with the U.S. but eventually the challenges faced by Australia’s largest trading partner could come back to haunt the currency. The Canadian dollar failed to participate in Thursday’s rally because there haven’t been any breakthroughs in trade talks between the U.S. and Canada. Apparently there were reports on Thursday that Trump told donors he would drop Canada from the U.S.-Mexico-Canada pact if they don’t agree to his terms. The talks haven’t broken down completely but Canadian Foreign Minister Freeland was the first to admit that plenty of work still needs to be done.
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