Risk of sell-off in EUR/GBP just increased heading into Non-Farm Payrolls

The EUR suffered broad based losses after the ECB President Mario Draghi basically sent a message to the markets that some kind of dovish adjustment in the bank’s QE program is in the offing in the short-term, especially if the situation in emerging markets (China) continues to worsen.

ECB ready to do more

ECB’s response to the recent turmoil in the markets indicates the bank is not comfortable with the strength in the EUR, which was mainly due to carry unwind. A risk-on currency prior to negative deposit rate, the EUR turned into a carry currency and was increasingly used since Q3 2014 to fund risk-on carry trades.

Consequently, the message is clear – if the china turmoil continues to rattle markets, the EUR would strengthen on carry unwind; something which the ECB is not comfortable with and thus, may actually increase its QE program.

The renewed dovish tilt, though hardly surprising, has increased the risk of a sharp sell-off in the EUR/GBP pair in case the US August month payrolls report paints an optimistic picture of the labor market.

NFP above 200K could weigh over the EUR

The Non-farm payrolls report due tomorrow is expected to show the US economy added 217K jobs in August, compared to 215K in July. The unemployment rate is seen dropping to 5.2% from 5.3%. The average hourly earnings are seen rising at 2.1% in August.

Considering August usually produces a drop in the payrolls number – seasonal weakness and given the pessimism in the markets, an NFP print above 200K would be enough to push up September and December rate hike bets. The probability of September rate hike may not matter much, since we are just two weeks short of September meet and still do not have any clear hint from Fed. However, a print above 200K would be enough to bolster December rate hike bets and strengthen the US dollar.

More importantly, it could clam market nerves. The risk aversion in the equities witnessed of late was more due to falling rate hike bets – negative sign for the US and global economy. Stability in the markets could reinforce Fed rate hike expectations. The combined effect would be bearish for the Euro as it would highlight the diverging monetary policy path adopted by the Fed and ECB.

Consequently, the EUR/GBP faces a risk of a sharp fall in case the NFP prints above 200K. The GBP too would come under pressure against the USD, however, the fall would be relatively less as compared to the drop in the EUR/USD, since the BOE is expected to follow Fed in raising rates.

EUR/GBP: 4 –hourly chart

• The chart shows a double top formation with a bearish RSI divergence. The neckline is located at 0.7244 (August 30 low).

• A break below 0.7244 opens doors for a target of 0.7100.

• Moreover, the cross is likely to remain under pressure so long as it trades below 0.74 levels. Consequently, bearish pressure may persist even in case of an NFP print below 200K. However, risk of a break above 0.74 increases in case NFP drops below 200K.

The risk to the bearish view is obviously from an NFP print below 200K accompanied by a sharp drop in average earnings.