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EUR Prime for a Breakout on ECB

The euro is prime for a breakout.  Unlike other major currency pairs, EUR/USD traded in a relatively tight range throughout the European and North American sessions.  On a technical basis, the currency pair stayed between the 100 and 200-day SMAs for the past 48 hours, which reflects the hesitation of investors who are waiting for a catalyst to take the currency pair out of its range.  Tomorrow could be the perfect opportunity for a breakout in the pair with the European Central Bank scheduled to deliver its monetary policy decision.  The ECB is widely expected to leave interest rates unchanged leaving Mario Draghi’s press conference as the primary focus for FX traders.

Since the last monetary policy meeting, we have seen both improvements and deterioration in Eurozone data.  There were no revisions to PMI services today but Eurozone retail sales dropped more than expected.  Up until this weekend when ECB President Draghi noted “few signs of possible stabilization” in the Eurozone and said he expects a “very gradual recovery” later this year, the head of the central bank seemed to be a larger advocate for negative rates. This contrasts with some of the skepticism on the effectiveness of negative rates expressed by Nowotny, Mersch, Asmussen and Noyer, all members of the Governing Council.  Nonetheless, economic conditions have not deteriorated enough to warrant this nuclear option and Draghi won’t be looking to it rule out on Thursday.  Instead, the head of the central bank will carefully balance a slightly more optimistic outlook for the economy with an open mind on negative rates.  As this may be confusing to investors, clarification could come from the central bank’s latest economic forecasts.  While we are optimistic that the EUR could rally, we are not particularly hopeful as the ECB will want to avoid saying anything that could drive the euro sharply higher.  So if Draghi emphasizes the possibility of negative rates over improving data, the EUR/USD could reverse its rise.  If he focuses on the bright spots in the economy however the EUR/USD could squeeze higher and finally muster a strong break of 1.31.

Dollar – Under Pressure from Weaker Data and Beige Book

While the U.S. dollar’s performance has been erratic, the underlying sentiment towards the dollar is clear.  Disappointing U.S. economic data raised fresh concerns about the outlook for Friday’s non-farm payrolls report and these worries have led to profit taking in the currency and equity markets.  The dollar fell sharply against the Japanese Yen as traders reduce their long USD/JPY positions.  It also weakened against European currencies and only strengthened against the AUD and NZD because those currencies are battling their own problems.  Expectations for tapering by the Federal Reserve were pared after this morning’s releases. The ISM non-manufacturing index rose to 53.7 from 53.1 in May, reflecting a small increase in service sector activity. However any optimism was erased quickly when investors took a look at the employment component of the report, which declined from 52 to 50.1 last month. As one of the market’s favorite leading indicators for non-farm payrolls, the decline in this subcomponent of ISM could reset expectations for Friday’s release.  Up until now, economists were looking for payrolls to rise by 167K (from 165K the previous month) but looking at today’s numbers, we feel that traders will adjust their positions to discount the possibility of a downside surprise. According to ADP, U.S. companies added only 135K jobs to their payrolls in the month of May.  While this was more than the previous month, the increase fell short of expectations.  The details of the report showed the service sector adding 138K jobs and the manufacturing sector shedding 3K jobs, the second decline in a row. With both the manufacturing and service sectors experiencing weaker job growth in May, the recovery in the labor market could be losing momentum.  We will know for sure on Friday but right now, the price action in USD/JPY shows that traders are cutting their long dollar positions and the Beige Book report did not help.  According to a survey published by the central bank, the economy expanded at a “modest to moderate pace” over the past 2 months. While there were improvements in services, construction and manufacturing activity, “hiring increased at a measured pace in several districts, with some contacts noting difficulty finding qualified workers.”  Their lack of clear optimism kept pressure on the U.S. dollar and U.S. stocks throughout the North American trading session.

JPY – Hit Hard By Global Deleveraging

With disappointing economic data coming in from around the world, the currency and equity markets have been hit by another case of deleveraging.  As a result, the Japanese Yen traded sharply higher against all of the major currencies.  The steepest losses were seen in AUD/JPY but USD/JPY also fell approximately 0.85%.  The persistent decline in Japanese stocks is weighing heavily on USD/JPY.  The Nikkei dropped another 3.8% overnight, taking its total two-week losses to over 16.5%. Investors were disappointed by Prime Minister Shinzo Abe’s structural reform agenda and its lack of new measures to overhaul corporate taxes, immigration and deregulation. The recent decline is one of the primary reasons why USD/JPY has been selling off aggressively.  The Bank of Japan won’t be happy with the volatility in Japanese stocks and could attempt to stabilize the market by increasing the frequency of JGBs purchased next week.  We can’t imagine that the central bank would sit by idly and just watch Japanese stocks fall as quickly as they have without taking some type of action verbally or physically and action by the BoJ would help to stem the slide in USD/JPY. The Ministry of Finance’s weekly portfolio flow data is due for release this evening.  If the numbers continue to show net sales of foreign bonds by Japanese investors, USD/JPY could extend its losses to 98.

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