FX Update: Clouds gathering over the euro.

Today's Saxo Market Call podcast

FX Trading focus:

• Economic outlook in Eurozone worsening, especially in Germany – this puts euro at risk, but will ECB do enough this Thursday to weaken the euro?
• China stimulus hopes boosts Antipodeans

Fresh data out this morning shows the deepening funk in the Eurozone and particularly in Germany. The German IFO survey for July was out this morning showing a worse than expected drop in the Current Assessment part of the survey, which dropped to 91.3 from 93.7 in June (and versus 93.0 expected). The Expectations component was slightly better than expected at 83.5 vs. 83.4 expected, but still falling directionally from the upward revised 83.8 (from 83.6) in June. Perhaps worse, the ECB’s quarterly bank lending survey was out this morning and showed a record drop in corporate loan demand (to lowest since 2003 start of the survey), with demand for mortgages and consumer credit also coming in lower. Some 14% of banks tightened credit standards further after 27% did so in Q1, while banks noted a deteriorating access to funding.

In reaction, the euro traded marginally lower to new local lows in places. It is no secret that the ECB has pulled in its hawkish talons of late, and forward expectations have dropped rapidly relative to the US, taking the 2y2y EU-US spread (the difference between the market’s pricing of the EU vs. US 2-year yield, two years into the future) is nearly matching its lowest level since last November, with the 10-year German Bund- US 10-year yield spread poised near its lows for the year as well. And yet, EURUSD has merely removed the latest aggressive extension to the upside beyond the former high water mark near 1.1095 and a bit. Why are we not trading lower? Clearly, it isn’t just about the rate differentials but also chiefly about factors like sentiment and the markets currently in the middle of the “USD smile”, a paradigm that suggests as long as the Fed is not on the war path with policy tightening and markets are generally complacent, the USD has little chance of staging a meaningful rally. So to get a proper reversal in EURUSD and close back below 1.1000, we’ll likely need to see a more determined turn lower in risk sentiment.

It is a bit harder to understand why EURJPY should be up here as the outlook for Europe continues to worsen, and if the ECB rate tightening is done as long as inflation is directionally easing and the growth trajectory continues to suffer. An added impact on EURJPY can of course come from an eventual Bank of Japan policy tweak, even if that tweak may not be forthcoming at this Friday’s Bank of Japan meeting. For the ECB to really smash the euro and send a strong signal of concern, they would have to skip this week’s pre-committed rate hike. Instead, the more likely “most dovish” scenario is that we get the expected hike, but a quite firm removal of any guidance on further tightening by upping concern on the status of the Eurozone economy. This would likely remove the bulk of the current 50/50 odds of one last ECB hike by year end.

Chart: EURJPY

If this Thursday’s ECB brings dovish guidance and the Bank of Japan even merely flags a possible tweak down the road, much less an actual move to expand its yield-curve-control band this Friday, EURJPY could be set for a powerful move lower. We have a local bearish reversal here after Friday’s sharply rally has since been erased, but further technical evidence that this year’s bull market is coming unwound would require a close back below the 153.50 area pivot low from earlier this month. Bigger picture, the pair really needs to reverse out the bulk of the gains since 150 for a more emphatic signal that the extraordinary period of policy divergence is ending and we are headed in the direction of convergence for the next year or more.