Forex Outlook: Dangerous Mix Of Policy And Data Alignment

We know that EUR/USD and U.S. stocks traded lower yesterday on concern that Europe's leaders will disappoint at this week's EU Summit. Yet the lack of support for sharing sovereign credit risk from the Germans is not the only threat to the euro.

By prolonging the debt crisis at a time when economic data around the world is weakening, European leaders are creating a dangerous mix for risky assets around the world including the EUR/USD. According to the latest CFTC IMM data on speculative positions, traders have cut their short EUR/USD exposure in anticipation of progress on the policy front.

This means that should policymakers fail to convince the market that a fiscal union is in the works, those who have cut their shorts could return to the market and sell euros again. The only thing preventing the EUR/USD from revisiting its year to date low at 1.2288 is blind faith in politicians. Without that, we are left with weaker investor and business confidence, slower manufacturing and service sector activity in Germany as well as recessionary conditions in many Eurozone nations.

Growth in the U.S. and China is also slowing, posing a triple threat to the global economy. If European leaders fail to support the markets with policies that will end the debt crisis, the EUR/USD could make fresh year to date lows.

Everything lies in the hands of German Chancellor Merkel and unfortunately based on her comments this morning, she continues to oppose the very measures that are needed to turn Europe around. In her speech, she blamed the euro debt crisis on Europeans living beyond their means and crushed everyone's hope for a ground breaking announcement on Friday by saying that it is counterproductive to share euro-debt burden.

Merkel left no room for ambiguity when she rejected joint euro bonds and bills and joint deposit insurance if it means joint liability. She also expressed concern that investors were fixating too much on sharing debt, which confirms that the Germans are not relenting. Unless Merkel softens her stance on burden sharing, this week's EU Summit will most likely end up being a major disappointment for the EUR/USD.

While Angela Merkel will be heavily outnumbered at the EU Summit, she controls the purse strings and without her nod of approval, Europe will not be able to get the clear roadmap that it needs to reverse the vicious cycle that pushed so many nations into begging for a bailout.

Along these lines, Spain formally requested aid to recapitalize its banks yesterday, sending Spanish 10 year bond yields higher. Cyprus also requested financial aid from the emergency bailout fund, making it the fifth nation in the Eurozone to beg for lifeline.

While we don't know yet whether they will need a bank bailout only or a broader sovereign bailout, it is terrible news for the euro either way. The currency pair took the news in stride but this news will add pressure to the euro, which we expect to remain weak going into the EU Summit unless of course Germany suddenly makes a U-Turn and decides to come to the rescue of her distressed neighbors by sharing their debt burden - which is unlikely.

USD: Stronger New Home Sales Fail to Lend Support to Risk
Concerns about Europe drove investors back into the arms of safe haven currencies. Both the U.S. dollar and the Japanese Yen performed extremely well yesterday with the latter appreciating against all other majors. The weakness of USD/JPY confirms that risk aversion dominated trading as investors shrugged off the upside surprise in U.S. data.

Sales of new homes in the U.S. was the only piece of important economic data on the calendar yesterday. According to the latest report, new home sales rose 7.6 percent to 369k in the month of May. This was the highest amount of homes sold since Nov 2009. The supply of new homes also dropped to its lowest level since October 2005.

While this data is very encouraging, it is important to realize that inventory is only moving because prices are dropping. The recovery in the housing market is expected to continue to lag the recovery in the broader economy and for this reason the improvement in new home sales will not soften the case for QE3. Consumer confidence and the Richmond Fed manufacturing index are due for release today. Given the sharp decline in sentiment reported in similar surveys conducted by Investors Business Daily and the University of Michigan, there is a good chance that today's report will confirm that consumers grew less pessimistic in the month of June.

As for the manufacturing sector, weakness in the Empire State and Philadelphia regions signals a broad based slowdown in the sector that will most likely hit the Richmond area as well. Overall, like new home sales, none of these reports are expected to diminish the chance of another round of asset purchases from the Federal Reserve.

GBP: Lack of Data Equals Quiet Trading
The British pound strengthened against the euro and held steady against the U.S. dollar. The quiet trading of sterling reflects the lack of U.K. economic reports yesterday morning. In fact, it should be a relatively quiet week in the U.K. with only public sector finances scheduled for release today and final U.K. GDP numbers due on Thursday. The most important thing to remember about the U.K. is that the Bank of England is at the brink of easing monetary policy again and the prospect of more stimulus should hang over the British pound.

Public Sector net borrowing is expected to turn positive in May. Borrowing figures tends to be volatile and rarely has much impact on the currency but the latest numbers should show the country on course to meet this year's borrowing projection of GBP92 billion. We continue to expect the British pound to trade on risk appetite and expectations for the EU Summit. If traders remain nervous, the GBP/USD will suffer as a result.

AUD: Potential Problems in China's Demand for Coal
The Australian, New Zealand and Canadian dollars weakened against the greenback as the Eurozone crisis intensified with Cyprus becoming the fifth Eurozone nation to ask for a bailout. With no economic reports released from any of the 3 commodity producing countries over the past 24 hours and no data expected overnight, the commodity currencies traded on risk appetite alone yesterday.

The Australian dollar suffered the most because risk aversion raises the odds of additional easing from the Reserve Bank. The New Zealand dollar fell the least thanks to recent upside surprises in economic data.

This weekend, there was an article in the NY Times talking about how Chinese data masks the depth of the slowdown in the economy according to Chinese and Western economists. The argument centers on the record amount of coal that has accumulated in the country's storage areas. "Power plants are burning less coal in the face of tumbling electricity demand. Electricity production and consumption have been considered a telltale sign of a wide variety of economic activity." 

Considering that Australia is a major supplier of coal to China, if this report is true, Chinese demand for coal could start to decline. Gold prices edged higher while oil prices declined slightly. Like the British pound, we expect risk appetite to determine the next moves in commodity currencies.

 JPY: Debate Over Consumption Tax
The Japanese yen strengthened against all major currencies as the equity markets extend their losses on concern that the European Union summit will fail to end the Euro crisis. One of the biggest stories in Japan right now is the vote on a tax hike that will come before Parliament today. Prime Minister Noda proposed the hike as a measure to raise revenue and reduce the nation's swelling debt. Unfortunately a contentious battle is brewing within Japan's ruling party that could threaten Noda's popularity.

Granted, the planned tax is harsh with the 5 percent consumption tax set to be raised to 8 percent in April 2014 and then to 10 percent by October 2015. Doubling the consumption tax in 3 years could deal a big blow to Japan's economy and minimize any chance of recovery. According to local media reports, more than 50 members of the ruling party plan to oppose the bill but with support from the opposition, the tax could still pass.

However even if it does, the tax could make Noda deeply unpopular within his own party and among Japanese voters. Small business confidence and corporate service price index are due for release this evening. A small uptick in prices is expected in the month of May.