The first week of August will be a busy one for the financial markets. Employment reports are due for release from the U.S., Canada and New Zealand along with central bank meetings in Australia and the U.K. August is traditionally a challenging month for stocks and today we got a glimpse of the potential seasonal impact. The Dow Jones Industrial Average hit a record high at the start of NY trade but gave up all its gains by the end of the day. U.S. data was weaker than expected with the ISM manufacturing index sinking to 59.5 from 60.6. Economists predicted a pickup in manufacturing activity but shortages of raw materials and shift in spending to services caused activity to slow. Overall the number is still strong, particularly given the sharp rise in the unemployment index but that did not stop the U.S. dollar from following Treasury yields lower. The big story today was the plunge in yields – at one point 10 year rates were down 5 percent
Tonight’s Reserve Bank of Australia monetary policy announcement will be one to watch. The Australian dollar was one of the best performers on Monday but most Australian banks are calling for the RBA to renege on its plan to taper bond purchases from September forward. The initial announcement to taper bond buys was made on July 5th. At the time Melbourne was coming out of a lockdown and Sydney just went into what was supposed to be a 2 week long snap lockdown. Darwin, Perth and Brisbane also tightened restrictions which meant that more than 12 million Australians were in lockdown but the period was expected to be short. Fast forward a few weeks and lockdowns in Brisbane and Sydney were extended with Sydney marking its sixth week under stay at home orders. All of this has and will continue to take a toll on Australia’s economy as the country faces a reasonable chance of contraction in the third quarter.
Delaying taper plans is a no brainer for the RBA. The only question is whether they will simply push it to October/November or leave it open ended. The worst case scenario for the Australian dollar would be if they reverse their taper call and provide no precise delay date. In this scenario we could easily see AUD/USD drop to fresh 8 month lows. If they delay taper by only a month or two AUD/USD traders will be disappointed and AUD/USD could still drop to 8 month lows as that’s less than a cent away, but the losses will be milder than an open ended delay or a straight up reversal with no new plans. However if the RBA shrugs off lockdowns and keep their plans to start tapering bond purchases in September intact, AUD/USD will rip higher with a likely move towards 75 cents.
As the year progresses, differences in monetary policy direction will become a stronger driving force for currencies. This week’s Australia and U.K. rate decisions will highlight the divergence between two countries with vastly different COVID situations. Large parts of Australia were in lockdown in July whereas the U.K. removed all restrictions last month. The Bank of England will be debating a further reduction in bond purchases. Divergences like these are not unique to these two countries and as they become more apparent, the impact on currency pairs will be more significant.
Managing Director of FX Strategy BK Asset Management