Euro Follows Stocks Lower As Stalling Manufacturing Dims Growth Outlook

EUR/USD

The EUR/USD extended its recent losses as traders remain cautious with the domestic and global growth picture dimming. A disappointing Euro-zone PMI reading only added to traders concerns, as the gauge of the manufacturing and service industries slipped to 56.1 from 56.7. The manufacturing sector saw the biggest decline as its pace of expansion slowed to 55.0 from 56.7. The release itself didn’t spark a significant reaction which is surprising since the pair has seen its correlation with interest rate expectations strengthen to 53% from 34% a month ago. However that relationship could begin to weaken if slower growth dims yield expectations. Meanwhile, risk sentiment continues to be a driver of price action with a 45% correlation. Although the relationship has faded from 54% a week ago, it is due to the fact that the decline in stocks has outpaced that of the pair, but they both remain in a bearish trend.

EUR/USD Continues to Take Its Cue From Risk

ECB Interest Rate Expectations

Signs that manufacturing is slowing in Europe should keep the ECB cautious and on the sidelines for the remainder of the year. The pace of inflation accelerated to 1.7% -it’s fastest since November, 2008, but remains below the central bank’s 2.0% target. Price growth could be held in check if activity slows. Overnight Index Swaps reflect the dour outlook for yields with markets only pricing in 29 bps in tightening over the next year. Nevertheless, a rate hike in early 2011 can’t be ruled out which will increase the market moving potential of domestic fundamentals-especially inflation. Therefore, traders will want to keep an eye on the upcoming German CPI report for August on Friday as economist are forecasting a slowdown in price growth to 1.1% from 1.2% in the region’s largest economy. If inflation falls below 1.0%, it could raise deflation concerns and weigh on the Euro. Discuss this and trading ideas join the EUR/USD forum.

FOMC Interest Rate Expectations

An unexpected contraction in manufacturing in the Philadelphia area combined with initial jobless claims rising above the half million mark has sparked fears that the U.S. economy is headed for a double dip recession. Policy makers are now expected to add stimulus measures, instead of removing them before the end of the year -as was expected when 2010 began. Indeed, we can see that Fed Fund futures are now giving a zero percent chance of rate hike by the end of the year. Forecasts for a 3.0% rise in U.S. durable goods orders could ease double dip fears but may not alter yield expectations, but a lower revision in 2Q GDP could add to the dovish outlook.

Risk

Growth concerns continue to grow which has kept stocks under pressure as markets ended lower for a third straight day. However, a spike in M&A activity has tempered losses but if fundamentals continue to weaken the current bearish trend will continue. The 50.0% Fibo of 9614-10,719 held as support at 10,167 but downside potential remains to the 61.8% Fibo at 10,036. Discuss this and other fundamental data in the Economics Forum.

To discuss this report or be added to the email list contact John Rivera, Currency Analyst: jrivera@fxcm.com