Single Currency Primed For A Breakout

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. Thursday 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 euro-zone data. There were no revisions to PMI services Wednesday but euro-zone retail sales dropped more than expected. Up until this weekend when ECB President Draghi noted "few signs of possible stabilization" in the euro zone 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 nonfarm 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 nonfarm 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 Wednesday'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 two 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.

AUD: Down Nearly 10% From April Highs
The Australian dollar continues to be the worst performing G20 currency. It dropped another 1% against the U.S. dollar and euro, putting its total losses from its April high at slightly under 10%. The first round of selling occurred in Asia but when U.S. data surprised to the downside, risk aversion drove the AUD/USD even lower. The currency fell to a fresh 1.5 year low against the greenback, stopping just short of the psychologically significant level of 95 cents. Service sector activity and GDP growth fell short of expectations. Unlike the manufacturing sector which enjoyed a strong recovery in May, the service sector contracted at a faster pace last month. The Australian economy also grew 0.6%, compared to a forecast of 0.7% and this drove the annualized pace of GDP growth down to 2.5% from 3.2%. Not only is growth now below trend but it has also reached its slowest level since 2011 and explains why the RBA refuses to drop their bias to lower interest rates again. With the trade balance scheduled for release Wednesday tonight, the AUD could experience further volatility. At this stage, the only trigger for a turnaround in the AUD is U.S. data and even that may not be enough. The New Zealand dollar also lost another percent as investors heed the RBNZ's warning. The central bank made it very clear that they are not happy with the rise in the NZD against the AUD and will take action to weaken their currency if this trend does not end soon. As a result, investors have also taken the NZD lower, stemming the slide in AUD/NZD. The Canadian dollar on the other hand did not participate in the sell-off. The loonie ended the day virtually unchanged against the greenback after Canadian building permits jumped 10.5%. The IVEY PMI report is scheduled for release Thursday and economists expect a sharp increase in manufacturing activity. If they are right, the CAD could recover some of its recent losses.

GBP: BoE To Leave Policy Unchanged At King's Final Meeting Better than expected economic data continues to fuel gains in the British pound. With the service sector expanding alongside manufacturing and construction, the U.K. economy is still on the track to recovery. This is the fifth straight month that we have seen activity improve in the service sector with the PMI index rising to its highest level in more than a year. For the Bank of England, these consistent improvements reduce the need for additional easing. Last month, the central bank did not believe that the improvements can be sustained but with service and manufacturing activity accelerating, it will be hard for them to ignore the underlying improvements in the economy. The Bank of England, who started their two day meeting this morning is widely expected to leave monetary policy unchanged. The economy is not strong enough to warrant monetary tightening and has not deteriorated enough to warrant easing. However according to Markit Economics (the agency that releases the PMI surveys), "The UK economy has moved up a gear with all cylinders now firing. The increasing buoyant picture and improved outlook painted by the PMIs effectively kills off any chance of the Bank of England's Monetary Policy Committee voting for more stimulus such as asset purchases for the foreseeable future." While we can't say that easing is completely off the table because Mark Carney could take a completely different approach when he becomes BoE Governor, there no reason for the central bank to change policy Thursday. In fact, when the minutes are released we suspect that there will be a general sense of relief from policymakers.

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