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USDOLLAR Breakout Lacks EUR/USD Participation; Preview for ECB

USDOLLAR Breakout Lacks EUR/USD Participation; Preview for ECB

Christopher Vecchio, CFA,

Talking Points:

- USDOLLAR Index breaches March 10 bearish key reversal high.

- ECB needs to make a few adjustments to its bond buying program.

- As market volatility stays elevated post-Brexit, it's a good time to review risk management principles.

As the USDOLLAR Index shakes off the rust of its three-week congestion, there is one driver that is noticeably absent: EUR/USD. In part, this may be due to the ongoing rally in equity markets and stability in GBP/USD: for the former, demand for risky assets reduces the need for US Dollars; for the latter, lack of developments (negative or otherwise) on the Brexit front has a lid on the Euro's existential crisis.

Accordingly, EUR/USD is lacking a sincere driver at the moment, at least on the Euro's side. There is the European Central Bank's July policy meeting tomorrow, one at which in the immediate aftermath of the Brexit vote was rife with potential for surprise action. Instead, however, the stability in financial markets will most likely allow the ECB to keep rates on hold tomorrow, staying with the pattern of only making a significant change to policy when the staff economic projections (SEP) are released (next: September).

There are two things to watch for, if this meeting is going to be used as a runway to potential action at the end of Q3 or the beginning of Q4. First would be any language regarding the timetable for the QE program. Currently, it is set to end in March 2017; seeing the seeds planted for another six-month extension to September 2017 seems very possible.

Second, given the downdraft in core sovereign bond yields in recent weeks, the ECB will indicate that it needs to adjust the way its bond buying program is conducted. The ECB allots its bond buying based on the capital key. What is the capital key? The capital of the ECB comes from the national central banks (NCBs) of all EU member states. According to the ECB, the NCBs’ shares in this capital are calculated using a key which reflects the respective country’s share in the total population and gross domestic product of the EU.

As such, it's no surprise that Germany - as the country with the largest capital key contribution - has seen the belly of its yield curve (3Y-7Y) drift lower into negative territory, below the ECB's -0.40% deposit level - the threshold at which the ECB no longer purchases bonds in its QE program. Likewise, the ECB needs to either: remove the limiting parameter of -0.40% on its bond buying; or discard the capital key variable. In the first case, German yields would like move lower the fastest; in the second, peripheral yields.

See the above video for a technical review of the USDOLLAR Index, EUR/USD, USD/JPY, and GBP/USD. If you haven't yet, read the Q3'16 Euro Forecast, "Euro Awakes to Brexit Nightmare; Time for a Turn in EUR/USD?" as well as the rest of all of DailyFX's Q3'16 quarterly forecasts.

Read more: USDOLLAR Index Breaking 3-Week Range on Back of AUD/USD

--- Written by Christopher Vecchio, Currency Strategist

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