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EUR/USD Drivers from Both Sides of the Pond

EUR/USD Drivers from Both Sides of the Pond

Kathy Lien, Technical Strategist

This week’s economic data and statements from central bank leaders Ben Bernanke and Mario Draghi have the power to cause swift short-term price fluctuations in the EURUSD pair.

This is an important week for the euro (EUR). For the past month, investors have been selling euros and buying dollars on the premise that the Eurozone is in recession, the US is in recovery, and the EuropeanCentral Bank (ECB) is considering more stimulus at a time when the Fed is considering less. All of these assumptions will be tested this week with key event risks on both sides of the Atlantic.

For the euro, the question is whether economic conditions continued to deteriorate in March, a development that would boost the odds of additional stimulus from the ECB. The latest Eurozone PMI numbers will be released this week along with the German IFO report. Economists are looking for a small recovery in manufacturing and service sector activity, and if they are right, the euro could extend its gains.

A few hours after the PMI numbers are released on Thursday, ECB President Mario Draghi will speak about the future of Europe in the global economy. If the data shows a deeper contraction in Europe and Draghi reminds investors that the central bank is watching economic data carefully to see if additional action is necessary, EURUSD could extend its losses.

While we believe that the euro could still experience further losses, this could be a week of recovery for the currency. Eventually, Europe will start to reap the benefits of lower interest rates and a weaker currency, which is exactly why Draghi may not say anything to threaten the current downtrend in the euro.

At the same time, Fed Chairman Ben Bernanke's testimony to the Joint Economic Committee and the Federal Open Market Committee (FOMC) minutes pose a double threat to the dollar rally. Even if the EURUSD rebounds, it may turn out to be nothing more than a short-term recovery. We need to see a consistent improvement in the Eurozone economy and a broad-based deterioration in US data beyond manufacturing for investors to reconsider their expectations for ECB and Fed policy.

For the time being, 1.28 is the most important near-term support level for the EURUSD. The currency pair rebounded off this level on Friday and extended its recovery on Monday. EURUSD also found support around this same area in late March /early April, making it even more significant, but the rally should be capped at 1.30. If Eurozone data surprises to the downside and EURUSD takes out 1.28, then the next major support for the pair will be at 1.2740.

The Big Threat to the US Dollar Rally

US economic data will take a back seat to Bernanke's testimony and the FOMC minutes on Wednesday. The relentless rally in the US dollar over the past month indicates that investors are pricing in a major change in Fed policy, and Bernanke's comments could either support or end the dollar rally.

If Bernanke drops even the smallest hint about the Fed varying bond buying—either by talking about it directly or sounding more optimistic about the outlook for the US economy—the dollar could hit new highs. However, if he spends more time talking about the constraints in the US economy and the fiscal drag, the dollar could fall quickly and aggressively as speculators cut their long dollar positions after realizing that mapping an exit to quantitative easing (QE) doesn't mean that the Fed is ready to head that way.

See also: The #1 Threat to the Dollar Rally This Week

Fast Gains from Last Week’s Big Losers

The Australian dollar (AUD) and New Zealand dollar (NZD) performed extremely well on Monday, as the currencies that experienced the deepest losses last week recovered the fastest. Whether gains in the AUD would be sustained, however, would hinge largely on the latest Reserve Bank of Australia (RBA) meeting minutes, which were released last night.

The RBA minutes essentially reaffirmed the Bank’s position and offered no evidence that the Australian central bank is thinking of cutting rates further in the foreseeable future. The AUDUSD rallied in the aftermath of the release, but the move above .9800 soon fizzled as fresh sellers pushed the pair back below that figure. Still, AUDUSD appears to have stabilized at the .9700 level and is likely to consolidate for the time being.

Meanwhile, Monday’s best-performing currency was the New Zealand dollar, which was up more than 1% thanks to better-than-expected service sector activity in April. Overall, New Zealand data hasn't been nearly as weak as other countries.

Higher oil prices also spurred a recovery in the Canadian dollar (CAD), but compared to the AUD and NZD, the gains were limited.

Inflation Data Sends British Pound (GBP) Tumbling

Better-than-expected UK economic data continues to lend support to the British pound (GBP), which traded higher against the euro and US dollar on Monday. House prices rose 2.1% in the month of May, which drove the year-over-year gain in house prices to 2.5% from 0.4%. According to the property Web site, prices hit a record high this month, driven largely by demand for property in London.

This was a great start for sterling this week, as we have a tremendous amount of UK data on the economic calendar.

Today, however, weaker-than-expected inflation data sent GBPUSD tumbling in early-London trade as investors feared that a lack of price pressures would provide the Bank of England (BoE) with more leeway to increase QE. Sterling fell to a low of 1.5163, coming within a few pips of testing the 1.5150 support before stabilizing a bit at 1.5175.

UK CPI printed at 2.4% versus 2.8% expected while the core reading dropped to 2.0%. This was the lowest reading since 2009 and suggests that the UK economy may have finally beaten the chronic inflation that has plagued it for the past four years.

Although the news on the price front should ultimately prove positive for the UK economy because it will likely improve real growth and lower costs for the UK consumer, the currency markets reacted negatively to the news.

Forex traders feared that the lack of pricing pressures may encourage incoming BoE chief Mark Carney to increase the size of the QE program in order to further stimulate growth. However, with UK economic data already showing a rebound, Mr. Carney and the rest of the monetary policy committee may feel little need to increase QE for now.

Tomorrow's UK retail sales data may prove crucial for GBPUSD. If the data, which is expected to increase from the month prior, surprises to the upside, cable could quickly recover its losses and head towards 1.5300 as the combination of lower inflation and better growth will assuage any market concerns.

Japan’s Amari Backpedals Recent Yen Comments

Meanwhile, in Japan, Economic Minister Akira Amari backpedaled from his comments on Sunday, saying that they may have been improperly translated into English. Mr. Amari said that he "Hoped that exchange levels will settle so they match the basic strength of the Japanese economy" but added that he "won't comment on whether it has in fact been corrected, or to where it would be corrected, or whether (the correction) is over."

This idea was then further reinforced by a Wall Street Journal article, which quoted unnamed sources among Japanese policymakers who stated that they were ready for more yen weakness. One senior official said that, "the weaker yen provides more benefits than harm for the economy overall." The net impact of this news was a swift turnaround in USDJPY trade with the pair as bid today as it was offered yesterday.

However, despite the positive news flow, USDJPY still could not climb above yesterday's highs and remains capped under 103.00 for now. The markets are no doubt waiting for tomorrow's testimony from Fed Chairman Ben Bernanke to see if Fed policy is starting to shift to a more neutral stance.

By Kathy Lien and Boris Schlossberg of BK Asset Management

DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.