Euro Slips, but will it Break?

The US dollar is posting modest gains against most of the major currencies. The Australian dollar is a the main exception. Following the government's nonchalant attitude last week, the central bank governor failed to mention the exchange rate in a speech. This seems to be emboldening the bulls to some extent.

However, it is the euro's retreat that is the main focus today. After a quiet Asian session, it broke down in early Europe and came within a tick of the year's low set in February just below $1.3480. The weekly trend line going back to 2012 comes in near $1.3470 remains intact.

There did not seem to be a precipitating trigger of the move. Instead, yesterday's bounce after pushing below $1.35 before the weekend was not convincing. In addition, there is some anticipation of the economic data in the coming days pushing in opposite directions. The US reports June CPI figures today and the euro area flash July PMI is due Thursday. US inflation has accelerated slightly in recent months. The German central bank warned that the biggest economy in the euro area may have stalled in Q2 and that the euro area economy also is stagnating or worse.

At the same time, there was much interest in the ECB's 7-day repo today. There were two elements. First, there was 99.9 bln euros repos maturing and last week, banks indicated they would pay back a large 21.5 bln euros of the LTRO. This is among the largest weekly repayments. There was some fears that this would lead to a significant drain of excess liquidity in the banking system. Instead, banks seems to simply shift from the LTRO to shorter repo operation, leading to a small net drain of 2 bln euros at today's operation.

Sterling is faring better. It is within yesterday’s trading range, which itself was within last Friday’s range. The CBI Trends survey was softer than expected, and the budget deficit was larger than expected, but the focus is on tomorrow’s release of the MPC minutes. Given the data (higher CPI, tighter labor market—except for wages) many are expecting a hawkish tint. The UK will also report June retail sales tomorrow. They are expected to have bounced back after the May weakness.

Meanwhile, the dollar is at three-day highs against the Japanese yen, helped perhaps by firmer US yields and the rise of the Nikkei, after yesterday’s holiday. The dollar is testing the 20-day moving average near JPY101.60. That moving average appears to have helped check dollar upticks for the past couple of weeks.

Macro news from Japan was poor. Contrary to local press reports, the Japanese government cut its growth forecast for this fiscal year to 1.2% from 1.4%. Recall last week, the BOJ shaved its growth forecasts to 1.0% from 1.1%. The early official optimism regarding the impact of the sales tax increase on April 1 has faded. The economy likely contracted in Q2 and the key is its performance in Q3.

Separately, we note that Abe support continues to erode. The latest survey has his support at 46.6, down 6.4-percentage points and the lowest since he took office (for the second time). His disapproval rating rose 5.4-percentage points to also stand at 46.6. Abe has spent his political good will on controversial policies, like pushing for the restart of nuclear plants and a more militaristic interpretation of the Constitution. The LDP lost the recent election in the Shiga prefecture.

The US reports June CPI today. The consensus forecast for a 0.3% rise in the headline and 0.2% rise at the core would keep the year-over-year rates steady at 2.1% and 2.0% respectively. The Fed’s preferred inflation measure is the core PCE deflator. In May it stood at 1.5%, 0.5% below the core CPI measure. This is an unusually wide gap.

Barring a significant surprise, the Federal Reserve is expected to announce at next week’s meeting another $10 bln of tapering to bring its purchases down to $25 bln a month. There seems to be a slight chance of a dissent in favor of expediting the tapering given the recent employment and inflation reports that indicate the Fed is nearly achieving its mandates.

Lastly, the EU foreign ministers are meeting. The focus is on the Ukraine and the response to the downing of the commercial plane last week. While a tough statement may be issued, European officials will more likely want to wait for the official investigation to confirm what intelligence already indicates. Russian asset markets are recovering from yesterday’s slide. The MICEX is up almost 2%, and the 10-year bond yield is off 8 bp to 9.02%. The dollar is trading at three-day lows against the ruble.