By Kathy Lien, Managing Director of FX Strategy for BK Asset Management.
The euro exploded higher after centrist Emmanuel Macron “won” the first round of the French Presidential election. Of all the probable scenarios, this was the best outcome for the euro, which explains why EUR/USD gapped above 1.09 when the markets opened for trading on Sunday evening. Although the EUR/USD would have taken out 1.10 if Marine Le Pen failed to advance to the final round of voting, the chance of that was extremely low. Instead, investors are satisfied that the polls in France have been accurate and that Macron has a good chance of a sweeping victory over Le Pen on May 7. France would be set on 2 very different courses depending upon who wins the election. Macron is pro euro, pro EU whereas Le Pen wants a referendum on EU membership shortly after her victory. With this in mind, there has been very little follow through in the euro during the Asia, European and North American trading sessions, leading investors to wonder if the gap near 1.0730 will be filled.
While it can be argued that we won’t know who the final winner will be for 2 more weeks, Macron has a very good chance of winning so there’s less need for investors to hedge against a Le Pen victory. Unlike the euro, French stocks have largely held onto their gains, which is a sign of investor confidence. The latest German IFO report also supports a stronger currency with the business confidence index rising to 112.9 from 112.4. However there are 2 big risks for the euro this week – the first is Thursday’s European Central Bank monetary policy announcement and the second is a tax reform announcement by U.S. President Trump on Wednesday. The ECB has been uncomfortable with the market’s hawkish interpretation of their last monetary policy decision and while data has been largely better, inflation remains very low. The central bank wants the market to understand that policy is accommodative and will remain so for the foreseeable future and if that’s emphasized on Thursday, the euro could fill its gap quickly. But that could also happen before the central bank’s announcement if progress is made on U.S. healthcare and tax reform. A large part of the dollar’s rally after the U.S. election was driven by the prospect of lower taxes and with tax cuts back in focus, the dollar is starting the week strong. Until we are assured that progress on U.S. tax reform won’t be announced this week and the ECB won’t hurt the euro with dovish comments, the chance of the gap in EUR/USD being filled is greater than the chance of a move to 1.0950.
The U.S. dollar moved higher against all of the major currencies Monday despite dovish comments from Fed President Kashkari. Politics is in center focus for the greenback this week as investors look to President Trump for a “big” announcement on tax reform. There are few things going on this week. The U.S. government is at the brink of another shutdown on Friday. There’s a lot of debate over the funding of a border wall and subsidies over Obamacare – big issues that won’t be resolved in the next few days. With a Republican controlled Congress, the chance of a shutdown is slim. The last time the federal government was shut down was in 2013 and that was a power struggle between a Republican controlled Congress and a Democratic White House. The Republicans are in control so we’re likely to see a temporary extension with lawmakers passing a short-term spending bill that will keep the government running while longer-term measures are negotiated. Therefore we don’t see a government shutdown as a major risk for the dollar.
Instead, investors are hopeful that President Trump will deliver on his promise for “a big announcement on tax reform” on Wednesday. While the dollar could hold bid ahead of his announcement, we worry that investors will be sorely disappointed. The White House has said that Trump will be “outlining principles for tax reform,” which is basically nothing more than a wish list. According to Mick Mulvaney, the director of the White House Office of Management and Budget, “I think what you’re going to see on Wednesday is some specific governing principles, some guidance. Also some indication of what the rates are going to be. I don’t think…anybody expects us to rollout bill language on Wednesday. In fact, we don’t want to do that.” During his campaign Trump said he wanted to cut the corporate tax rate to 15% from 35% and reduce the number of tax brackets, bringing the highest tax rate down to 25% from 39.6%. Republicans and Democrats are pushing for less dramatic changes and that continues to be the most likely scenario for tax reform. However Trump is a master at getting his constituents and the market excited so we’ll have to see how well he sells his tax reform plans on Wednesday. New home sales, consumer confidence, house prices and the Richmond Fed index are scheduled for release Tuesday but these reports are likely to take a backseat to policy headlines.
Having traded as high as 1.2850, sterling has come under selling pressure at the start of the week. With no major U.K. economic reports scheduled for release until GDP on Friday, GBP/USD is taking its cue from the market’s appetite for U.S. dollars. We thought that sterling would catch a bid from French election relief but it hasn’t and the euro is coming off its highs. On a technical basis, 1.2755 is the main support level for GBP/USD. If that gives, the currency pair should fall quickly to 1.2700. EUR/GBP, on the other hand, appears to have found some resistance at the 20-day SMA, which coincides with the overnight high of 0.8510.
All three of the commodity currencies traded lower against the greenback Monday as the risk-on rally faded. Lower commodity prices and a stronger U.S. dollar also contributed to the move. This is a busy week for the commodity currencies with many important economic reports scheduled for release starting Tuesday evening. We are watching USD/CAD closely as the currency pair flirts with 1.35. No data was released Monday but retail sales are due on Wednesday followed by GDP on Friday. USD/CAD flamed out near 1.35 back in March and has not broken above 1.36 over the past year. Recent data has been disappointing with existing home sales and consumer price growth slowing. On a fundamental and technical basis, USD/CAD appears poised for a test of 1.36.