Euro Refuses to Fall Ahead of ECB Meeting

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Daily FX Market Roundup 09-05-12

Euro Refuses to Fall Ahead of ECB Meeting
USD: Will the Fed Fall Behind the ECB?
GBP: BoE Meeting to be Nonevent for the British Pound
CAD: Bank of Canada Remains Hawkish But…
AUD: Q2 GDP Misses
NZD: Chinese HSBC Services Report Surprises to Downside
JPY: BoJ Member Issues Warning about Economy

Euro Refuses to Fall Ahead of ECB Meeting

Judgment day is here. On Thursday, we will learn if ECB President Draghi has what it takes to control and cap bond yields in the Eurozone once and for all. Based on the price action of the EUR/USD, investors are hopeful that the central bank won’t disappoint and deliver an interest rate cut along with a detailed plan for bond purchases. Over the past few trading days, the EUR/USD has been trapped in a very tight range and despite repeated attempts to drive the currency lower it refuses to fall. During the early European trading session, the EUR/USD fell to a low of 1.25 only to recover all of its losses to end the day higher against the U.S. dollar. ECB President Draghi has pledged to do “whatever it takes” to save the euro and if their first, second and third tries don’t work, they will try and try again. Having introduced the idea of a new bond purchase program aimed at the short end of the yield curve at the last monetary policy meeting, ECB President Draghi has set the stage for a big announcement. Since the August meeting, investors and economists have had plenty of time to think about what the central bank will do and position accordingly. While most experts agree that the ECB’s plans could fall short in terms of specifics, the fact that EUR/USD is hovering near its 2 month high indicate that investors are not positioned for a disappointment. Thursday promises to be a very volatile day for the euro with the currency pair first reacting to the rate decision and then to ECB President Draghi’s press conference. The market is currently pricing in a 25bp rate cut but only slightly more than 50% of the 58 economists surveyed by Bloomberg expect the central bank to ease. The lack of consensus ensures a reaction in the EUR/USD to the 7:45AM ET ECB monetary policy announcement and the 8:30AM ET press conference by Mario Draghi. For more on what the ECB could do, please read our ECB Preview: 6 Key Questions for Super Mario.

The best case scenario for the euro would be a 25bp rate cut, explicit euro denominated target for unsterilized bond purchases and a yield cap. While a rate cut is normally negative for a currency, in this case, if it is accompanied by a thoroughly flushed out bond purchase program investors could end up buying euros on the optimism that the ECB’s efforts will finally help to control funding costs in the region. The worst case scenario for the euro would be no rate cut and an unfinished proposal for buying short term bonds. If the ECB leaves plenty of room for interpretation, hinges their decision on the German Court’s approval of the ESM and indicates that bond purchases will be sterilized, investors could express their disappointment by selling euros. Sterilizing bond purchases is negative for the euro because it offsets the impact that the purchases would have on money supply and hence limit its effectiveness on the economy. While we hope for the best, we have to prepare for the worst because central banks rarely like to be as explicit as investors want and the ECB in particular may not want commit to specifics before knowing how much support member nations will need.

USD: Will the Fed Fall Behind the ECB?

Currencies and equities traded higher today thanks to a general sense of optimism in the financial markets. Central banks are gearing up to inject another dose of unconventional stimulus and investors hope that this will help to enough to mitigate further problems and invigorate economies in the Eurozone and the U.S. Last week Fed Chairman Ben Bernanke had an opportunity to set stage for easier monetary policy in the U.S. but he failed to do so, leaving the market guessing what the central bank will do next week. The ECB on the other hand has said loud and clear that they are taking additional steps to lower borrowing costs and if the ECB moves forward with cutting rates tomorrow, the Federal Reserve could find themselves in the position of falling behind the ECB on the track to ease. If Bernanke passes on any changes in monetary policy next week and the ECB eases on Thursday, a new trend could emerge in the EUR/USD. No major U.S. economic reports were released today but we did learn that non-farm productivity increased in the second quarter and mortgage applications continue to fall, albeit at a slower pace this past week. While the focus will be on the euro and the ECB meeting tomorrow, the leading indicators that we track ahead of non-farm payrolls are also scheduled for release. This includes the ADP employment change, Challenger Job Cuts, jobless claims and ISM Non-manufacturing reports. A decline is expected in nearly all of these measures because job growth in August is expected to slow. July’s 163k increase in payrolls was a pleasant surprise that is not expected to be matched or beaten in the month of August.

GBP: BoE Meeting to be Nonevent for the British Pound

The British Pound ended the North American trading session slightly higher against the U.S. dollar. No major economic reports were released from the U.K. this morning but the Bank of England is gearing up for a monetary policy announcement on Thursday. Unlike the ECB however, the BoE is not expected to changes to interest rates or the size of their asset purchase program. Thanks to the stimulative impact of the Olympics, there’s little urgency within the BoE. Recent economic data has also shown an uptick in service and manufacturing activity that eases the pressures on the central bank to act. When the monetary policy committee makes no changes, very little details are provided to the market, which means that the BoE rate announcement should be nonevent for the British pound. Sterling will instead trade on risk appetite and the market’s reaction to the ECB’s decision. We will have to wait until September 19th when the Bank of England minutes are released for more insight into what the BoE is thinking.

CAD: Bank of Canada Remains Hawkish But…

While the Bank of Canada reiterated its view that “some modest withdrawal of the present considerable monetary stimulus may become appropriate,” the Canadian dollar traded lower against the greenback. This hawkish monetary policy stance from the BoC should have lent support to the currency because it confirms that Canada is the only G7 nation looking to raise interest rates but the price action suggests that the market believes the BoC is overly optimistic. The central bank is still concerned about the external headwinds that could weigh on economic growth but they felt that the underlying momentum in the economy was consistent with their expectations. The recent increase in oil prices supports the central bank’s rosy outlook but the strength of the Canadian dollar hurts exports. The central bank could be delaying changes to their monetary policy stance until after the ECB and Federal Reserve’s rate decisions. If the market responds positively to both, the Canadians will remain hawkish but if the market sells off, then they may need to downgrade their optimism. The Australian dollar also dropped below 1.02 on the back of weaker GDP numbers. Australia’s economy expanded by 0.6% in the second quarter, down from 1.4% in Q1. While the country experienced its 21st consecutive year of positive growth, “currency markets focused on the marked slowdown in household consumption which rose only 0.3% versus 1.0% the quarter prior as consumers curtailed spending. The slowdown in final demand was evident in Monday’s Retail Sales which contracted sharply to -0.8% versus 0.3% expected gain” according to our colleague Boris Schlossberg. Employment numbers are due for release from Australia this evening and unfortunately job growth is expected to slow, which could add pressure on the Aussie.

JPY: BoJ Member Issues Warning about Economy

It was another mixed day for the Japanese Yen which weakened against the commodity currencies, held steady against the U.S. dollar, traded lower against the euro and British pound. No economic reports were released from Japan overnight but Bank of Japan Board Member Miyao warned of heightened risks to the Japanese economy, the possibility that exports may not pick up in time to support growth and said the “BOJ must scrutinise the outlook of Japan’s economy and prices. We must also take careful and bold steps when necessary.” There’s no question that the weakness in the U.S., Eurozone and China has threatened the country’s export sector and the strong yen only adds to the pain. According to HSBC, service sector activity in China expanded at a slower pace in the month of August. The index dropped from 53.1 to 52 and paints a different picture of the performance the service sector than the government’s official reading, which reported an increase a day prior.

Kathy Lien
Managing Director

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