Behind the Bizarre Breakdown in the Euro

• Behind the Bizarre Breakdown in the Euro
• USD: Softer CPI Won't Stop Fed From Tapering Next Week
• GBP Hangs Tight Ahead of BoE Minutes
• Will CPI Break AUD Out of its 93/95 Range?
• CAD: All Eyes on Retail Sales
• NZD: Gold and Oil Retreat
• Japanese Yen Unfazed by Lower Growth Forecasts

Behind the Bizarre Breakdown in the Euro

The euro fell to an 8 month low against the U.S. dollar today for no specific reason and that makes us extremely skeptical of the sustainability of EUR/USD's decline. In the short term, the conflict between Israel and Gaza as well as the ongoing investigation into flight MH17 is a big focus of the global community but for investors, the rebound in the Dow and the decline in VIX indicate that the uncertainty has not translated into increased concerns for market participants.  In other words, we can't necessarily blame the decline in the euro on tensions with Russia. In fact, EU ministers failed to agree on new economic sanctions at today's meeting in Brussels.  The only agreement was for visa bans and asset freezes on more Russian officials. While a weak response from the EU was widely expected, it should have been positive and not negative for the euro because of the lower risk that it poses to the Eurozone economy.  At the same time, no economic reports were released from the region and the German-US yield spread moved in favor of the euro. The only explanation for the sell-off in EUR/USD is a technical one. The currency pair has been in a downtrend and hovering near 1.35 for the past few days with speculators itching to test this key support level.  Expectations for a weaker PMI and IFO report may have also contributed to the move but these reports are not expected until Thursday.  In the long run, we believe EUR/USD should be trading comfortably below 1.35, but not until there is significant upside momentum in U.S. yields.  The last time EUR/USD was this weak was when the European Central Bank surprised the market with a 25bp rate cut.  Since the risk of further easing from the ECB right now is low we believe that EUR/USD won't spend much time below 1.35.

USD: Softer CPI Won't Stop Fed From Tapering Next Week

The U.S. dollar appreciated against most of the major currencies today. The highly anticipated consumer price report proved to be a big disappointment in terms of the volatility it created for currencies and the trend of inflation.  CPI growth slowed to 0.3% in the month of June after rising for 3 consecutive months.  Excluding the rise in food and energy costs, price growth slowed to 0.1% from 0.3%. On an annualized basis, headline CPI growth remained unchanged at 2.1% but core growth slowed to 1.9%, validating the Federal Reserve's cautious monetary policy stance. While we expect the Fed to taper asset purchases by another $10 billion next week, we do not anticipate a rush to raise interest rates.  In all likelihood, the FOMC statement will contain absolutely no reference to when rates will rise.  Existing home sales rose 2.6% in June, which was more than expected but not good enough to offset the downside CPI surprise.  The modest increase in U.S. yields and new highs in S&P 500 confirm that investors do not believe that today's reports are a game changer for the Fed.

GBP Hangs Tight Ahead of BoE Minutes

The British pound extended its losses against the U.S. dollar for the fourth consecutive trading day as investors cut their long positions ahead of the Bank of England minutes.  The minutes are the most important event risk for sterling this month because the mixed messages from policymakers have left investors confused on how serious the central bank is about raising interest rates in late 2014, early 2015.  BoE Governor Carney first suggested that rates could rise sooner but he later admitted that the comments were aimed at resetting market expectations because they believed that investors were underpricing the possibility of tightening. Over the past month, we have seen deterioration in trade activity, decline in retail sales and drop in the PMI index, making investors worried about a less hawkish bias.   When the minutes from the June meeting was released, sterling fell aggressively because it did not contain an explanation for Carney's hawkishness.  The tone was balanced with no policymakers dissenting from the decision to keep monetary policy steady.  With speculative positions still at extreme levels, a neutral policy stance could drive sterling to 1.70.  However if there is any official suggestion that rates could rise sooner as some policymakers have suggested since June, GBP/USD could easily recover all of its losses and make its way towards 1.72. 

Will CPI Break AUD Out of its 93/95 Range?

Between Australia's consumer price report, Canada's retail sales number, the Reserve Bank of New Zealand's monetary policy announcement and HSBC's Manufacturing Flash PMI index for China, commodity currencies are in focus over the next 48 hours. Both the Australian and Canadian dollars have been trapped in narrow ranges versus the greenback and Wednesday's economic reports have the potential to break the consolidation in the AUD/USD and USD/CAD, although the chance is low unless there is a significant surprise.  We start the day off with Australian consumer prices.  Given the drop in commodity prices in the second quarter, the odds favor a downside surprise that could erase the gains in the Australian dollar.   CPI is generally an important report but with RBA Governor Glenn Stevens saying last night that, "if policy could reasonably do more, we would consider it," slower inflation growth could reinforce the dovish views of the central bank and drive the currency towards 93 cents.  A break below this level would probably require CPI growth to slow to 0.3% or lower.  As for Canada, economists are looking for a sharp slowdown in consumer spending in the month of May. However between the uptick in jobs that month and the sharp increase in wholesale sales, we believe that the risk is to the upside, which could help to drive USD/CAD to 1.08.  However in order for this resistance level to break, retail sales would probably need to exceed 1%. The RBNZ rate decision and Chinese PMI are scheduled for Thursday.

Japanese Yen Unfazed by Lower Growth Forecasts

For the second time this week, there was very little consistency in the performance of the Japanese Yen. The rebound in Treasury yields, rise in the Dow and Nikkei was mildly positive for USD/JPY but the strength failed to carry through to the Yen crosses.  Last night's Japanese economic reports were mixed with the all industry activity index rising but supermarket store and convenience store sales falling.  The leading index was also revised lower for the month of May. We are beginning to see cracks in Japan's post sales tax recovery and this may have motivated the Japanese government's decision to lower their 2014 growth forecast. The government now sees real GDP growth of 1.2% in the 2014 Fiscal Year versus a previous estimate of 1.4%. This downgrade was triggered by expectations for weak export growth, stronger imports and the impact of the consumption tax. Their nominal GDP growth forecast, which is not adjusted for inflation was left unchanged at 3.3%, reflecting progress on the inflation front. Even with the downgrade, the Cabinet said they see the economy entering a "virtuous cycle" where a rise in consumption will lead to increased production and higher wage growth.  Overall the outlook for the economy remains bright with one of Japan's leading newspapers reporting that 70% of retail shops and restaurants have a problem finding available part-time workers which is another step in the right direction.