Post date: 01/10/2018 08:00
Last week's dollar rally came under somewhat unusual circumstances. Federal Reserve communications were somewhat on the dovish side and a drop in US treasury rates. However, sot inflation print across the Atlantic and the standoff over the Italian budget tanked the Euro and dragged down every European currency Sterling outperformed in relative terms, as some of the negativity around the Salzburg talks was unwound. Emerging markets had a mixed week, with Latina American currencies generally bouncing back strongly while Asian ones continued to unperformed dragged down by US-China trade tension.
Next week promises to be a volatile one, as headlines from the UK Conservative Party conference will compete with those from Italian politics to drive Euro and Sterling. The week will be capped by the key US monthly payroll report on Friday.
Last week vindicated our view that current Sterling levels vs the Euro and the dollar are pricing in something close to a worst-case scenario, and that the mere absence of bad news leads to Pound outperformance. This view will be tested again this week as the governing Conservative Party conference kicks off, with the consequent danger of negative headlines. Beyond Brexit, the PMI business activity surveys out Wednesday will focus attention.
The news that the Italian budget by the right-populist government would reach 2.4% of GDP a year for the next three years, considerably higher than the targets previously agreed with the European Commission, put the Euro on a wrong foot all week. The soft flash inflation news did not help, and put in serious question Draghi's optimism that it is on a path to reach the ECB targets over the medium term. While headline news came out mostly as expected, the more important core indicator, which excludes volatile food and energy components dipped below 1% again. Our call for ECB hikes in Q3 2018 is contingent on a sustained pick up in this critical indicator, and so far we are not seeing it.
The Fed widely expected hike in rates last week was coupled with a somewhat dovish assessment of the long-term equilibrium rates, and a suggestion that it no longer regards current policy settings as accommodative and we make be closer to the end of the hiking cycle than most observers think. While Treasury yields reacted as one would expect and fell, the dollar did not, as European political troubles overshadowed this news.
Friday we have another date with the key US payroll report. The headline is expected to stay strong, but again the key will be to see whether tentative upward trend in wage gains we saw in the previous report is maintained.