All Eyes On Draghi, ECB Forecasts

EUR: Watch Draghi And ECB Staff Forecasts
For the past 7 trading days the euro has been confined within a 100-pip trading range, between 1.3526 and 1.3622 against the U.S. dollar. The currency pair is itching for a breakout and with the European Central Bank's monetary policy announcement on Thursday and the U.S. nonfarm payrolls report on Friday, we believe that a break could occur in the next 48 hours. Last month, the ECB surprised the market by cutting interest rates 25bp and sending EUR/USD sharply lower but the move only lasted one day as investors quickly came to conclusion that this would be the last move by the central bank this year. We agree that the ECB is done for the year as there is a 90% chance they will leave monetary policy unchanged Thursday. However that does not mean they are done easing period. In fact, we believe that it will be ECB President Draghi's intention to sound dovish because inflation is very low and economic data has been mixed. Since the last monetary policy meeting, we have seen consumer spending decline, service sector activity slow but manufacturing activity strengthen. Most of the improvements have been in Germany with the rest of the region lagging behind. Since the recovery is not broad-based, the ECB has every reason to keep monetary policy easy. Yet the real question for the central bank Thursday is whether negative interest rates is a realistic option. A number of ECB policymakers have said this is technically feasible but Draghi downplayed all of the speculation that the possibility is set to turn into reality.

For the time being, there is no immediate need for the ECB to ease again as November's move was likely an acceleration of plans originally intended for December. Draghi will most likely repeat that negative rates is possible but downplay the need for it at this time which should enough to keep the euro supported. However if sounds even more dovish than November and sends a strong signal to the market that more easing is possible, the euro drop could below 1.35. The central bank will also be releasing its latest forecasts for growth and inflation. If the ECB upgrades its inflation and ECB forecasts, it would support the euro but if they downgrade their forecasts which is less likely given the improvements in global growth and the impact of the latest rate cut, the euro would fall quickly and aggressively. So while the central bank is not expected to change monetary policy, Thursday should still be an active day for EUR/USD.

Dollar: Non-Manufacturing ISM Dip Raises Payrolls Miss Risk
It has been quite a volatile day for the U.S. dollar with mixed data and the Beige Book sending the currency on a rollercoaster ride. The upside surprise in ADP Employment, trade balance and new home sales was met with a drop in the non-manufacturing ISM index that signals the potential for weaker nonfarm payrolls. In November, private payroll provider ADP reported the largest amount of job growth this year. According to their report, U.S. companies added 215k jobs in November, up from 184k jobs the previous month. The October figures were also revised significantly higher, putting the release in line with the last month's strong nonfarm payrolls report. Unfortunately service sector activity slowed in November and more importantly, the employment component dropped to its lowest level since May. Based on this release, nonfarm payrolls could have slowed materially last month. Payrolls were originally expected to rebound strongly in November after falling sharply in October. However to everyone's surprise, job growth in October accelerated and based on the steep decline in the employment component of service sector ISM, we now believe that payrolls rose between 150k to 175k last month. Apparently, the U.S. government shutdown had very little impact on the hiring decisions and U.S. corporations hired evenly between October and November. It would be an easy decision for the Federal Reserve to taper if payrolls rose more than 200k for 2 months in a row.

Alternatively if it grew less than 125k in November they would probably keep the program unchanged this year. However the decision gets tricky if payrolls rise between 150k and 175k because arguments could be made both ways. Meanwhile the U.S. trade deficit narrowed for the first time in 4 months thanks to the record-breaking rise in exports. New home sales also jumped 25.4% in October the fastest pace of growth in 30 years. The Federal Reserve will be happy to see the improvements in the housing market and the signs of stronger global demand. In fact the Beige Book was relatively optimistic. The 12 Fed Districts said the economy is growing at a modest to moderate rate with hiring showing a modest increase or unchanged in the various districts. While most policymakers and many investors will reserve judgment until the nonfarm payrolls report is released on Friday, Wednesday's mixed releases should limit the dollar's rise ahead of NFPs.

GBP: No Changes Expected From BoE
Despite the decline in service sector activity, the British pound ended the day unchanged against the U.S. dollar. The Bank of England has a monetary policy announcement on Thursday and unlike the ECB, the meeting in the U.K. should be a nonevent for the British pound. We have seen more improvements than deterioration since the last central bank meeting but the skeptical policymakers on the Monetary Policy Committee are in no rush to express their satisfaction with the data. The central bank will keep policy unchanged and release their typically brief statement that will leave investors looking to the minutes due in 2 weeks time for more direction. In all likelihood, the central bank grew more optimistic but they are still a long way from raising interest rates. Even though we have seen improvements in manufacturing and construction sectors this week, service sector activity slowed with the PMI index dropping to 60 from 62.1. This pullback is not extremely concerning because the index also hit a 16 year-high last month. Therefore we continue to expect sterling to outperform the euro and other major currencies.

CAD: Hits Fresh 3-Year Lows On BoC Dovishness
The Canadian, Australian and New Zealand dollars all traded lower against the greenback Wednesday. While the Aussie led the losses, USD/CAD climbed to a fresh 3-year high. The Bank of Canada left interest rates unchanged Wednesday but the tone of their monetary policy statement was more dovish. Despite improvements in the U.S. economy, the BoC felt that the downside risks to inflation appear to be greater. If a central bank is concerned about price pressures, they are generally more inclined to keep monetary policy easy. The BoC acknowledged the improvements in the U.S. economy but expressed fresh concerns for growth in several emerging market nations, which could affect prices of Canada's economy. Having only recently dropped its bias to raise rates, we are not looking for a rate cut anytime soon from the Canadians. However if data continues to weaken, it could become a more serious possibility. Meanwhile the Australian dollar was hit hard by weaker than expected GDP growth. Economists had been looking for growth to rise in Q3 but instead it held steady at a downwardly revised 0.6%. On annualized basis, growth slowed to 2.3% from 2.4%. This miss overshadowed the uptick in service sector activity and sent the currency down 1% against the U.S. dollar. Weakness in mining investment has hit the country hard and stresses the raises for more support from the central bank. If Australian data does not improve anytime soon, the RBA could be forced to ease again. No New Zealand data was released but the NZD fell in sympathy with the AUD. Australian trade numbers are due for release Thursday along with Canada's IVEY PMI report. Yen Crosses Hit By Equity Weakness
With U.S. stocks falling for the fourth consecutive trading and the Nikkei dropping more than 2% overnight, Japanese Yen crosses traded lower across the board. Even USD/JPY fell victim to selling though the weakness in this pair can be attributed to softer U.S. data. No major Japanese economic reports were released from Japan last night. Labor cash earnings increased slightly in the month of October, a sign of improvement in Japan's economy. The Ministry of Finance's weekly portfolio flow report was due Wednesday evening and with U.S. yields climbing to their highest levels since late September, we expect more demand for foreign bonds by the Japanese. The greatest risk for Japan's economy next year is the consumption tax and according to BoJ Sato, there is no need to ease monetary policy preemptively if the pain on the economy from the consumption tax rate hike proved to be temporary. In other words, don't expect the central bank to act immediately if data starts to weaken after the tax is increased -- they will want to see if demand recovers the following month or so before taking action.

Kathy Lien, Managing Director of FX Strategy for BK Asset Management.