daily brief

Euro Remains Under Pressure As Falling Inflation Adds Pressure For ECB Rate Cuts

Tuesday, 06 January 2009 10:04:32 GMT  |  John Rivera, Currency Analyst

The Euro continue to remain under heavy selling pressure which was accelerated by the Euro-Zone CPI estimate slowing to 1.6% from 2.1% on the back of falling energy prices and waning demand. The Euro dropped nearly 300 bps falling below 1.3400 for the first time since December 15th as the inflation prediction beat estimates of 1.8%.

Talking Points
• Japanese Yen: Threatening 94.00
• Pound: Service Sector Continues to Contract
• Euro: Declining Inflation Raises Chances Of Rate Cut
• US Dollar: ISM Non-Manufacturing On Tap

Euro Remains Under Pressure As Falling Inflation Adds Pressure For ECB Rate Cuts

The Euro continue to remain under heavy selling pressure which was accelerated by the Euro-Zone CPI estimate slowing to 1.6% from 2.1% on the back of falling energy prices and waning demand. The Euro dropped nearly 300 bps falling below 1.3400 for the first time since December 15th as the inflation prediction beat estimates of 1.8%. Meanwhile, the final Euro-Zone service reading was revised slightly higher to 42.1 from the preliminary reading of 42.0, but contracted for a seventh month and despite the increase was the lowest reading on record.

The sharp fall in prices will raise deflation concerns which we saw yesterday has become a concern for the ECB. Therefore, expectations have grown that the central bank will lower their benchmark rate by another 25-50 bps at their January 15th meeting. Yet, Credit Suisse overnight index swaps saw a shape decline in expectations for rate cuts over the next twelve months to 65 bps from 153 bps on December 24th. Therefore, we may see the ECB signal an end to easing following another rate reduction which may see the single currency reverse its losses following the decision. Indeed, rising commodity prices on the back of an improved outlook for the global economy will alleviate some deflation concerns. However, expect the Euro to remain under pressure heading into the rate decision with it possibly targeting support at 1.2500.

The Pound traded higher despite choppy price action as weakening fundamental data and an expected rate cut have prevented a stronger bullish push. Indeed, the December Nationwide housing price gauge showed prices fell 2.5% which was the biggest drop since 1997 led to early Sterling weakness. The ever slumping housing sector has remained a burden for consumers and has sunk consumer confidence to an all time low of 47 in December. Meanwhile, the PMI service reading unexpectedly rose to 40.2 from 39.0 but still remained near a record low and the sector which accounts for the majority of growth in the country contracted for an eighth month. Despite the fundamental data suggesting an almost certain rate cut by the BoE, pound bulls haven’t been deterred leaving the possibility that a bottom may have been put in place at the December 31st low of 1.4351. A rate reduction could lead to another test of this price level, but beware of a subsequent reversal which tends to follow a rate change that is believed to be the final in a cycle.

The dollar remained mixed during overnight trading as it continues to gain against the Euro, Yen and Swiss Franc while losing ground against the Pound and Canadian Dollar. The upcoming ISM Non-manufacturing report may threaten bullish sentiment for the greenback as economists are predicting that the sector contracted further to set a fresh all-time low of 37.0 following November’s 37.3. Sharp declines in new orders led last month’s decline which may be a weighing factor for the sector that accounts for over 70% of GDP. Pending Home sales and factory orders for November will also present event risk as both are predicted to show further weakness. The deteriorating housing market and weak manufacturing sector were reasons cited by President –Elect Barack Obama for the proposed $710 billion in aide. The FOMC will also release their minutes from their last meeting where they lowered the benchmark interest rate to 0% -0.25%. Although the central bank doesn’t have room for more easing the minutes will give insights into the outlook for the economy. The MPC has recently taken up the cause to lower consumer borrowing costs which may include asking that TARP funds be used to purchase distressed assets as it was originally intended. The prospect of the U.S. consumer coming back on line may add longer term dollar support and an increase in risk appetite.

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To discuss this report contact John Rivera Currency Analyst: jrivera@fxcm.com

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