With no major U.S. economic data on the calendar this week, the focus for currency and equity traders will be third quarter earnings. For the equity market, the significance of earnings is obvious, but for currency traders, the number of positive and negative surprises affects risk appetite and with it demand for U.S. dollars. Over the past 2 weeks, we have seen country specific factors such as the decline in U.S. unemployment and weakening Australian growth play a larger role in the daily price action of currencies, but that could change with a major surprise in U.S. earnings.
Earnings are receiving more attention than usual this quarter because they are expected to fall for the first time in 11 quarters. Q3 is expected to be the worst earnings season in 3 years. Last week, the Dow Jones Industrial Average climbed to its highest in nearly 5 years, which is completely at odds with the level of U.S. growth and expectations for corporate earnings. This means corporate earnings could be a cold hard reality check for investors. Outside of the open-ended liquidity provided by central banks, there's very little justification for the strong rally that we have seen in equities and the improvement in risk appetite. Some currencies have started to weaken on the prospect of slower growth in the fourth quarter and it may only be a matter of time before other currency pairs such as the EUR/USD follow suit.
More than 75% of S&P 500 Companies Providing Guidance Warned of Lower Profits
While the unemployment rate in the U.S. dropped below 8% for the first time since 2009, the pace of the U.S. recovery is far from desirable. Millions of Americans are still out of work and few companies are hiring because consumers are not spending. Add slower growth in China and Europe to that equation and we can understand why more than 75% of the S&P 500 companies providing guidance see earnings falling short of analyst estimates. Nearly every one of those companies attributed their profit warnings to uncertainty in Europe and lower global trade.
Why are earnings important to forex traders? Because weak earnings could set off a reversal in U.S. stocks and cause a general sense of risk aversion that could push the U.S. dollar and Japanese Yen higher. In this market environment, risk on / risk off is still the biggest driver of demand for dollars. Currency traders have been treading cautiously in anticipation of fresh direction from economic data or news flow and disappointing earnings could trigger a turn in the euro and a deeper sell-off in the British pound and Australian dollar.
But Bar is Set So Low that Many Companies Could Also Over-Deliver…
Yet investor relations and corporate management of many S&P 500 companies have mastered the art of under-promising and over-delivering. Over the past 4 years, 72% of S&P 500 companies have beaten earnings estimates. The bar has been set so low by lowered expectations that better results could drive a further rise in equities and currencies. Who wouldn't want to look like a hero? Another alternative would be in line earnings and a brighter forecast for the fourth quarter, which would still be positive for risk appetite. Better than expected earnings could drive the dollar lower against all of the major currency pairs except for the Japanese Yen. However, don't expect an improvement in risk appetite to be significantly negative for the dollar because there is still greater uncertainty in the eurozone and Asia.
Either way, the sustainability of risk appetite will be tested by third quarter earnings, which kick off unofficially with Alcoa's (NYSE:AA) report after the bell on Tuesday. The lack of major U.S. economic reports this week means that earnings could receive more attention than usual. However, will earnings affect the long-term trend of the U.S. dollar? Probably not. Just like the stronger labor market report on Friday, earnings will be nothing more than a distraction from the central bank's job of tackling the deep seated problems in the U.S. economy including high unemployment, weak consumer demand and cautious corporate investment and spending behaviors. It is important to remember that upside earnings surprises won't change the Fed's plans to maintain an open-ended Quantitative Easing program well into the New Year.
Happy Columbus Day - bond markets are closed for trading but the stock market is open.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.