The U.S. dollar is trading lower against all of the major currencies this morning after the ISM report showed manufacturing activity dipping into contractionary territory in the month of May. The primary driver of EUR/USD weakness over the past few months has been the divergence between growth of the U.S. and Eurozone and monetary policies. The downside surprise in U.S. data and upside surprise in Eurozone data could contribute to shifting expectations this week. While manufacturing reports are not game changers for the EUR or USD, they reflect the overall performance of the economy and could affect the European Central Bank’s monetary policy decision on Thursday.

According to the ISM manufacturing index, which dropped to 49.0 from 50.7 last month, manufacturing activity contracted at its fastest pace in 4 years. This is a bit of a headache for the Federal Reserve but their primary focus is the labor market and so, Friday’s non-farm payrolls report will be the number one U.S. event risk this week. If job growth is also disappointing and the tone of the European Central Bank is a bit more optimistic, the playing field could be altered, affecting how the EUR/USD trades.

Will the ECB Alter the Playing Field?

As we have seen in this morning’s Eurozone manufacturing PMI numbers, economic data in Europe is beginning to improve. The manufacturing sector did not contract as much as initially reported in the month of May. The index was revised up from 48.8 to 48.3 a 14 month high with improvements seen in both Germany and France. On Sunday, we heard some cautiously optimistic comments from ECB President Draghi that were later confirmed by the PMI reports. He said, there are “few signs of possible stabilization” in the Eurozone and they expect a “very gradual recovery” later this year. With the central bank gearing up to meet this week, these comments could be Draghi’s way of setting expectations for more a moderate and less pessimistic outlook on Thursday.

When the ECB last met, they doled out a big dose of easing by cutting their main refinancing rate by 25bp, their lending rate by 50bp and extending their fixed rate allotment until July of next year. On top of that they said they were willing to consider negative deposit rates. Draghi used the word weaker countless times in his introductory statement to describe the economy, said he was very worried about the labor market and warned that the weakness in growth expanded beyond the peripheral to core economies. His talk about stabilization and recovery on Sunday suggests that the central bank will not be nearly as grim which could alter the playing field for the EUR. Negative deposit rates are still on the table but we feel that the economy needs to deteriorate more significantly or European markets need to see additional volatility for the ECB to resort to this option.

Meanwhile European and U.S. investors are ignoring the ongoing deleveraging in Tokyo. The Nikkei dropped another 3.7% overnight putting their total losses at 15% over the past 2 weeks. If the S&P 500 dropped 15%, everyone would be screaming that the bull market is over and stocks around the world would decline but so far we haven’t seen much contagion and we are worried that we will soon.

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