Changing Fed policy and the latest US and Eurozone data, while significant, may not have the impact on EUR/USD price action as upcoming growth forecasts and the outcome of the Italian elections.
There are a number of US economic reports scheduled for release today, but the primary driver of dollar flows continues to be the Federal Open Market Committee (FOMC) meeting minutes released yesterday. The Fed is getting more serious about phasing out asset purchases, and this has led many traders to reverse their short dollar positions.
See related: Fed Hints About End of Quantitative Easing
Yet, while the greenback extended higher against the euro today, it gave up some gains against the British pound (GBP) and Japanese yen (JPY).
This lack of follow through in other pairs may reflect some skepticism about timing. According to the FOMC minutes, the central bank will re-evaluate its asset purchases next month, but they may not elect to formally taper asset purchases until later in the year. The slow pace of the US economic recovery and lack of significant inflationary pressures gives the Fed the flexibility to keep monetary policy easy, if they so desire.
This morning's CPI report showed consumer prices stagnating in the month of January and growing a mere 0.3%, excluding food and energy, which drove annualized CPI growth down to its lowest level in six months. Jobless claims rebounded to 362k from 341k, and while the data is still being distorted by estimates, it is nonetheless consistent with a slow recovery in the labor market.
Existing home sales and the Philadelphia Fed index will also be released Thursday, but we don't expect these reports to shift the outlook for the dollar significantly. The sharp improvement in manufacturing conditions in the NY region points to the possibility of a similar uptick in manufacturing conditions in Philadelphia, which would be positive for the greenback.
Our main focus now will be on comments from St. Louis Fed President James Bullard this afternoon. Three Fed Presidents are scheduled to speak today, but Bullard is the only FOMC voter. Right now, investors will be looking to upcoming speeches by US policymakers, including Fed Chairman Ben Bernanke next week, for affirmation of the Fed's new bias.
Between the FOMC minutes and this morning's weaker Eurozone PMI numbers, the euro has been pushed to a one-month low against the US dollar. While the currency pair has rebounded since then, there are two lingering questions that pose ongoing threats to the euro.
European Commission's Growth and Deficit Forecasts
One of the most important comments last week came from the head of European Sovereign Ratings at S&P. Moritz Kraemer warned that Spain, France, Italy, and Portugal are at risk of being downgraded this year. If this week's economic reports and European Commission growth forecasts suggest that this risk has increased, then the euro could be in big trouble.
See related:S&P Downgrade Rumors Rock EUR/GBP
The decline in Eurozone GDP growth in the fourth quarter raised concerns that the complete lack of growth last year and the prospects of a flat first quarter will make budget deficits in the region even more unsustainable. Therefore, the European Commission's growth, unemployment, and deficit forecasts will be extremely important. While it’s possible that the Commission will look beyond the contraction last year and focus on the signs of growth in the coming year, there could still be concerns about deficits and the currency, especially after today's weak PMI numbers.
Aside from the potential changes to growth estimates, we will also be looking to see if budget deficit forecasts are increased. If Spain's budget deficit is expected to exceed 8%, it could raise the risk of a downgrade for the Eurozone's fourth-largest economy. If, however, forecasts remain largely unchanged, it could help the euro.
Italian Election Uncertainty
The election in Italy is also a problem for the euro. The election is being held on February 24 and 25, and between Prime Minister Mario Monti calling former Prime Minister and current opposition Silvio Berlusconi a buffoon and Berlusconi slurring in a speech, this will be an interesting one.
The leader of Italy's center left party, Pier Luigi Bersani, is neck to neck with Berlusconi, and while no one is expected to win a majority, right now, it appears that Bersani is leading slightly in the polls. If Bersani wins, he will most likely form a coalition government with Mario Monti's centrists, which is probably the best-case scenario since it would offer assurance of continued reform in Italy.
However, these elections are close and can still go either way. The worst-case for investors and the euro would be a win by Berlusconi because he plans to abolish unpopular property taxes that were the cornerstone of Monti's austerity measures. A return to the free-spending days of Berlusconi would be a big hit to confidence and would increase the risks of a downgrade for Italy.
For these reasons and others, the uncertainty surrounding the Italian elections poses a risk for the euro. If the outcome of either event is negative, the euro could resume its slide towards 1.31.
By Kathy Lien of BK Asset Management