By Kathy Lien, Managing Director of FX Strategy for BK Asset Management.
This is a week where nothing mattered more to currencies than politics. The U.S. dollar has been jockeyed around by major developments with perging impacts on the currency. Tax reform is of course the biggest focus and Thursday’s support from Senator John McCain, who said he would vote for the plan, is a major victory for the GOP. McCain was a key holdout and with his support, there’s a reasonable chance that the Senate version of the tax bill will pass on Friday. The U.S. dollar soared on the back of his announcement and is now positioned for a move above 113. With this mind, however, Thursday’s other big story was the report that Secretary of State Rex Tillerson will be ousted from President Trump’s cabinet and replaced by CIA Director Mike Pompeo. It is no secret that Trump and Tillerson disagree on many aspects of foreign policy but it is also important to understand that he has led the call for a more measured response to North Korea. The President has publicly criticized Tillerson for wasting his time on diplomatic outreach and with Pompeo, who has called for a more aggressive response at the helm, the odds of military action have increased significantly. North Korea poses a major risk to the dollar, so even though tax reform is good news for the greenback, it will not be a smooth ride higher if the U.S. moves beyond sanctions. Thursday’s U.S. economic reports were mixed with personal income holding steady while personal spending slowed. The Chicago PMI index beat expectations but slipped off 6-year highs, which signals a slowdown in Friday’s broader ISM manufacturing index. Sterling was Thursday’s best-performing currency, which extended its gains beyond 1.35. In a matter of 3 weeks, GBP/USD has soared over 400 pips as the prospects of an EU Brexit deal brighten. Earlier this week there were reports of an agreement on the Brexit bill and on Thursday there were reports that the EU and UK are close to a breakthrough on the Irish border. Nothing has been confirmed by the U.K. government or members of the European Union and we’re still seeing a lot of negative headlines with the EU screaming ‘not enough’ progress as the Northern Irish party threatens to withdraw its support for May. However as the clock ticks to next month’s EU summit, these headlines and the active Brexit talks have given investors hope that the talks are slowly unlocking as negotiators work toward meaningful progress. The U.K.’s manufacturing PMI report is due on Friday and we are looking for improvements that could extend the currency’s rally to 1.36. It was also a good day for euro, which recaptured 1.19 against the U.S. dollar. Stronger-than-expected Eurozone data and the improvement in risk appetite – characterized by new records in U.S. stocks – helped lift the currency on a day when the U.S. dollar also rallied. Although retail sales in Germany plunged in October, fewer people claimed unemployment benefits in November. The Eurozone unemployment rate also improved and most importantly, the Eurozone’s consumer price estimate ticked up to 1.5% from 1.4%. The increase wasn’t as large as the market had hoped, but the reports show growth and inflation moving in the right direction. Revisions to November PMIs are due on Friday. It is difficult to predict the direction of any revisions but if changes are made, they could have a near-term impact on the euro. We’re bullish USD and bullish EUR, which means we’re looking for EUR/JPY to hit 135. USD/CAD rocketed higher on the back of a rising U.S. dollar and lower oil prices. The OPEC meeting ended with an agreement to extend production cuts to the end of 2018. Non-OPEC nations are onboard but the agreement could be adjusted in June and for that reason, oil didn’t move significantly. The Canadian dollar will be in play Friday with GDP and labor-market data due for release. The sharp drop in the employment component of the IVEY PMI report and the slowdown in trade and retail sales in the third quarter suggest that the data could surprise to the downside, leading to further gains for USD/CAD. The Australian dollar ended the day unchanged while the New Zealand dollar extended its slide. NZD was hit by a slide in New Zealand building permits and a drop in business confidence while AUD was supported by stronger housing data and higher Chinese PMIs. Australia’s manufacturing PMI report was due Thursday evening along with New Zealand’s terms of trade. Although Australian activity could be supported by Chinese demand, both currencies are vulnerable to the market’s appetite for U.S. dollar, which means further losses are likely.