Euro rallies as China's stock market crashes but will the US Dollar fight back?

The beginning of this week was anything but quiet and smooth as yesterday we witnessed strong price action in most of the instruments we monitor in our daily report. The reason behind the elevated volatility over the past 24 hours has to do with China and its domestic stock market that has been in a state of meltdown over the past few weeks. Yesterday the Shanghai index dropped a staggering 8.5% which is the largest one-day decline in 8 years and the effects of it were felt across most money markets.

With the Chinese stock market having lost huge amounts of market value the repercussions are important to note down as both the Euro and the Dollar stand to be affected by that development. The Euro having been a very cheap currency in recent months due to the QE program currency in play by the ECB has funded larger amounts of stock transactions all over the world and as the Chinese stock market is falling and investors are pulling their money out the European currency is receiving large inflows. This explains the rally in the Euro during yesterday’s session and as the selloff in China continues the Euro will receive more support from it.

At the same time the fact that one of the biggest stock markets in the world is in a state of shock and is losing market capitalization rapidly doesn’t bode well for the Fed’s plans to raise rates soon. This is not to mean that the Fed will take a step back and reconsider tightening their policy but it means that there’s one more thing for the policymakers to weight in before making their decision and when there’s increased doubt weakness creeps in. We’ll find out more on what is in Fed officials’ minds on Wednesday after the FOMC meeting.

In the meanwhile, the Euro enjoyed a very good session yesterday and rallied at the 1.1100 area after receiving massive flows from investors that were liquidating their stock positions in the Chinese markets. The sentiment in the currency hasn’t changed even though the IFO Survey yesterday has printed a bit higher, we expect more headwinds for the Euro as soon as Greece starts their negotiation with their creditors and if the Fed confirms expectations and mentions plans for tightening the rally could quickly be reversed. The 1.1050 area is considered an important pivot level for the days ahead.

The Cable rallied a bit higher during yesterday’s session and made it almost to the 1.5600 level but finally settled just above the 1.5550 area. The British currency was pretty volatile yesterday and we should expect further activity today as the release of the British GDP is scheduled for this morning. A possible retreat below the 1.5550 level could clear the way for the 1.5500 support area while fresh gains should drive the Cable towards the 1.5650 highs so it all comes down to how the report will print.