By Kathy Lien, Managing Director of FX Strategy for BK Asset Management
As the week draws to a close, politics is in central focus. There are two big deadlines looming – a potential U.S. government shutdown if a funding bill is not passed by Friday and a vote by the Social Democrats in Germany to begin talks with Angela Merkel on a grand coalition this weekend. With the clock ticking, the U.S. dollar and euro could come under selling pressure as investors take profits or cut their long positions ahead of these key event-risks. If members of Congress fail to a reach a deal or the SPD votes against a coalition, the dollar and euro will fall sharply. The U.S. dollar sold off across the board Thursday on the back of Sen. McConnell’s warning to plan for a shutdown, with some eleventh-hour scrambling, we still believe the GOP will secure enough votes to keep the government running and if we’re right, it should lead to a dollar recovery. But there will only be a bounce if they reach a deal because right now, investors still think that’s unlikely. Softer U.S. data compounded the dollar’s losses with housing starts and building permits falling. The Philadelphia manufacturing index also dropped to 22.2 from 26.2. Jobless claims hit a record low but investors shrugged off the improvement because claims can be very volatile this time of the year due to seasonal hiring. The University of Michigan’s consumer sentiment index is the only piece of U.S. data scheduled for release on Friday so developments in Washington will be the primary focus. For the fourth day in a row, EUR/USD held above 1.22, which is a testament to the amount of bids underneath this key level. As a former breakout point, it is holding firm but whether the pair takes out this week’s high or today’s low will depend on the outcome of SPD vote. Despite the resistance, leaders of the Social Democratic Party believe they will secure enough votes to win approval to move forward with a coalition deal and EUR/USD traders are hoping that’s e true because if they don’t EUR/USD will fall quickly and aggressively. ECB officials are growing uncomfortable with the euro’s strength and have begun to jawbone the currency. If we don’t see a pullback early next week, we expect ECB President Draghi to join the chorus of central bankers trying to talk the currency down. Although the account of the last meeting revealed policymakers looking to alter their guidance, between the rise in German yields and the strength of the currency, we don’t expect this change to occur at the ECB meeting next week. The risk of a disappointment makes EUR/USD vulnerable to a correction. However all of that depends upon political developments that are difficult to handicap. This uncertainty should limit a further breakout or breakdown in EUR/USD until the outcomes are known. Meanwhile, sterling comes back into focus on Friday with U.K. retail sales scheduled for release. We haven’t seen a pullback in sterling in 6 trading days and if spending beats expectations GBP/USD will most certainly hit 1.40. To the relief of sterling bulls, this week’s Parliamentary debate on Brexit provided no new headlines with MPs approving the key European Union (withdrawal) Bill by 29 votes, a win for Prime Minister May. Although economists are looking for spending to decline at the end of the year according to the British Retail Consortium, spending growth has held steady. With the bar so low, the data could beat. The Australian and New Zealand dollars extended their gains on the back of stronger-than-expected GDP data. Year-over-year growth held steady at 6.8%, against expectations for a decline but on a quarterly basis, growth slowed to 1.6% from 1.8%. Retail sales were also weaker but industrial production growth accelerated. Investors braced for uniformly weak data so the modest surprise helped take AUD/USD above 80 cents and NZD/USD above 73 cents. They also found Australian labor data satisfactory as job growth came in two times greater than expected. This improvement helped to offset the rise in the unemployment rate and the smaller increase in full time jobs. Although there was a more even mix of full and part time work, the latest report reinforces the labor market’s positive direction. The New Zealand dollar continued to power higher ahead of Thursday’s business PMI report. It will be interesting to see if the recent strength of NZD affected sentiment. USD/CAD tried to make a run for 1.25 but ended the day much closer to 1.24. The pair should remain under pressure following the Bank of Canada’s rate hike and its optimistic outlook for Canada’s economy.