Strong US data rallies Dollar and emerging market currencies; Sterling sinks on Bank of England cuts

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8 August 2016

thomasdodds

We were expecting fireworks last week and the currency markets did not disappoint.

O
n Thursday, the Bank of England cut rates and significantly added to its quantitative easing programme. The former was widely expected but the latter had only been pencilled in by a few strategists, ourselves included.

Then on Friday a very strong labour reports out of the US meant a September interest rate hike is now a definite possibility and it is not unlikely that we will see two US hikes in 2016.

Figure 1: US Nonfarm Payrolls (2010 – 2016)

The market reacted as one would expect, sending the US Dollar up and Sterling down. Less obviously, risk assets and emerging market currencies also rallied after the US labour report. Optimism about worldwide growth is starting to outweigh worries about higher US rates in the minds of investors.

This week should be a relatively quiet one. There is few market moving economic or policy news out of the Eurozone, US, UK or Japan and many traders and investors will try to enjoy the quiet in August vacations.

We expect major currencies to trade in tight ranges until the end of the month. The annual Jackson Hole conference of central banks will then take centre stage and we expect to see some clear communication from Federal Reserve Chair Janet Yellen on when to expect the next US rate hike.

Major currencies in detail:

GBP

The Bank of England largely validated our expectations for a rate cut and an increase in its quantitative easing target.

However, it went even further. It announced also that it would expand the asset purchasing programme to include corporate bonds. Most importantly, it announced a Term Funding Scheme to loan directly to banks and building societies.

The technical details of this latter programme are crucial. It allows banks to borrow directly from the Bank of England, rather than submitting Treasury bills as collateral. This will allow the Bank of England to separate funding costs of banks from the general level of interest rates and maintain a negligible cost of bank funding without forcing the general interest rate lower.

Sterling was rocked by this stronger-than-expected stimulus package and also by the long term pessimism implicit in the Bank of England’s post-Brexit forecasts. However, it managed to end the week nearly unchanged against the Euro and we note that the post-Brexit range of 1.30 – 1.35 is still holding.

EUR

Last week, the only macroeconomic news of note out of the Eurozone was a disappointing print in Germany’s June factory orders.

This week is likewise light on news. However, we will get second-quarter GDP growth estimates. This is a backward-looking indicator and thus of limited use in gauging how the Eurozone economy has responded to post-Brexit turmoil.

We expect the impact on FX markets to be muted and the Euro to trade in a tight range between 1.10 – 1.11.

USD

Any fears of a slowdown in the US economy were calmed by a very solid July jobs report released last week.

255,000 jobs were created in July, far outstripping both recent averages and consensus expectations. Hours and hourly earnings both increased and the total salary mass grew at an annualised rate of nearly 10%. There were also no blemishes in the household report, which showed both the labour force and labour participation to be up healthily.

Labour participation, in particular, was a key concern for the Federal Reserve and now chatter of a September rate hike has renewed. Markets see a high likelihood of at least one, possibly two hikes in the remainder of the year, buoying the US Dollar.

The US provides one of few focus points in G10 currency trading this week, as we receive the July retail sales estimates. Healthy growth in labour incomes over the past two months means that we expect to see a decent increase in this highly volatile indicator.

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