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Week Ahead - May 29, 2017

We are coming off the heels of an interesting week for the U.S. dollar which ended the week stronger versus the British pound, weaker versus the New Zealand dollar and basically unchanged against other major currencies.

This divergence can be explained by the market’s fading confidence in the Federal Reserve. Fed Fund future are pricing in 100% chance of a June hike but data and the FOMC minutes suggest otherwise so investors are waiting for a reason to swing one way or the other. CAD and NZD outperformed on local news whereas EUR and GBP were hit by growing uncertainty in inflation and/or the economy in Europe. Looking ahead Friday’s non-farm payrolls report will be the true test for the dollar.

The mighty buck lost its lustre after Federal Reserve minutes, which cast doubt on the central bank’s hawkishness. The problem was U.S. data and the FOMC minutes which failed to bolster the market’s confidence in a June hike. Although Bloomberg have Fed Fund futures showing a 100% chance of tightening next month new and existing home sales tumbled in the month of April, the trade deficit widened and jobless claims increased. Most importantly, according to the Fed minutes, U.S. policymakers are worried about the slow progress on inflation with some preferring to wait for evidence that the slowdown is transitory before taking action. So even if the Fed hikes next month, they’ll probably indicate that they are one and done. The inconsistency in data and market expectations makes this week’s event risks particularly important.

In many ways the dollar lives or dies by this month’s non-farm payrolls this month. If the jobs report is good which means non-farm payrolls increase, the unemployment rate holds steady and average hourly earnings rise at last month’s pace or better, the uncertainty about the Fed’s hawkishness will fade quickly, leading to a strong dollar recovery. However if any part of this Friday’s report disappoints, investors will start to unwind their long dollar trades, or worse start shorting dollars ahead of the June FOMC meeting. The Beige Book report is due for release on Wednesday and it will provide some clues on how the labour market is doing but the real test for the greenback will be NFPs as the outcome could set the tone for how the dollar trades for the next few weeks. Support in USD/JPY is at 110.30 and even if it rallies, it needs to clear 112.15 to remove the pair’s negative bias. Monday is a holiday in the U.S. so expect quieter trade.

Lastly sterling was the week’s worst performing currency. The terrible tragedy in Manchester combined with concern about Brexit negotiations prevented the GBP/USD from breaking above 1.30. The currency pair rose above this level on numerous occasions only to be met by heavy selling. First quarter GDP growth was revised lower (which is rare for the U.K.) and loans for house purchases eased. While this is significant, the market is still more concerned about the country’s escalated terror alert level and the tough negotiations with the E.U. Last week started with talk that the UK could walk away from Brexit negotiations if it is forced to pay their massive exit bill of as much as $100 Billion. At the same time the EU refuses to back down from their hard negotiating stance making the path forward difficult to perceive. Prime Minister May called for elections in June and her popularity has been negatively affected by some of the recent events in the country. GBP/USD is now trading below the 20-day SMA and likely to drop to 1.2700.

Five weeks have passed since EUR/USD gapped up from 1.0730 to 1.0880. There is a saying that gaps are meant to be filled and after such a long period of time, traders are still itching to drive the pair lower. After racing above 1.12, the currency pair ended the week below this key level. The near term political risks have faded and the latest economic reports were positive for the euro - German investor confidence rose strongly in the month of May, the Eurozone’s trade surplus hit a 3 month high and there were no revisions to the Eurozone’s Q1 GDP and French CPI reports. Even ECB President Draghi acknowledged the euro-area recovery as resilient and increasingly broad based. But EUR/USD has been unable to extend its gains for 2 main reasons - the first is slower inflation growth (prices are already rising at a more gradual rate and the rise in the currency puts further pressure on inflation). The second are the diverging views of the ECB and Federal Reserve. Mario Draghi made it clear that now is not the time to talk taper whereas practically every U.S. policymaker who spoke this month (aside from Kashkari) believes that further policy normalization is necessary. Let’s not forget that the Fed is the only major central bank talking about tightening and could increase interest rates by another 50bp this year. Of course, Friday’s U.S. job report could affect the market’s expectations and if the data is weak it would be wildly positive for the euro. If they are good, we could see EUR/USD head for 1.10. Eurozone inflation, confidence and German labour data are due for release – softer price pressures would reinforce the recent pullback in the euro.

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