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FX Update: Clouds gathering over the euro.

Forex
Picture of John Hardy
John Hardy

Head of FX Strategy

Summary:  Clouds are gathering over Europe, especially the deepening funk in German manufacturing after a weak IFO survey this morning and yesterday’s dire July Manufacturing PMI. Today also saw a weak ECB bank lending survey. Clearly, the clouds have been gathering over Europe, but at a time of a soaring euro exchange rate. Is it time for a reality check on the euro, or would the ECB have to do more than execute a dovish hike this week?


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FX Trading focus:

  • Economic outlook in Eurozone worsening, especially in Germany – this puts euro at risk, but will ECB do enough this Thursday to weaken the euro?
  • China stimulus hopes boosts Antipodeans

Fresh data out this morning shows the deepening funk in the Eurozone and particularly in Germany. The German IFO survey for July was out this morning showing a worse than expected drop in the Current Assessment part of the survey, which dropped to 91.3 from 93.7 in June (and versus 93.0 expected). The Expectations component was slightly better than expected at 83.5 vs. 83.4 expected, but still falling directionally from the upward revised 83.8 (from 83.6) in June. Perhaps worse, the ECB’s quarterly bank lending survey was out this morning and showed a record drop in corporate loan demand (to lowest since 2003 start of the survey), with demand for mortgages and consumer credit also coming in lower. Some 14% of banks tightened credit standards further after 27% did so in Q1, while banks noted a deteriorating access to funding.

In reaction, the euro traded marginally lower to new local lows in places. It is no secret that the ECB has pulled in its hawkish talons of late, and forward expectations have dropped rapidly relative to the US, taking the 2y2y EU-US spread (the difference between the market’s pricing of the EU vs. US 2-year yield, two years into the future) is nearly matching its lowest level since last November, with the 10-year German Bund- US 10-year yield spread poised near its lows for the year as well. And yet, EURUSD has merely removed the latest aggressive extension to the upside beyond the former high water mark near 1.1095 and a bit. Why are we not trading lower? Clearly, it isn’t just about the rate differentials but also chiefly about factors like sentiment and the markets currently in the middle of the “USD smile”, a paradigm that suggests as long as the Fed is not on the war path with policy tightening and markets are generally complacent, the USD has little chance of staging a meaningful rally. So to get a proper reversal in EURUSD and close back below 1.1000, we’ll likely need to see a more determined turn lower in risk sentiment.

It is a bit harder to understand why EURJPY should be up here as the outlook for Europe continues to worsen, and if the ECB rate tightening is done as long as inflation is directionally easing and the growth trajectory continues to suffer. An added impact on EURJPY can of course come from an eventual Bank of Japan policy tweak, even if that tweak may not be forthcoming at this Friday’s Bank of Japan meeting. For the ECB to really smash the euro and send a strong signal of concern, they would have to skip this week’s pre-committed rate hike. Instead, the more likely “most dovish” scenario is that we get the expected hike, but a quite firm removal of any guidance on further tightening by upping concern on the status of the Eurozone economy. This would likely remove the bulk of the current 50/50 odds of one last ECB hike by year end.

Chart: EURJPY

If this Thursday’s ECB brings dovish guidance and the Bank of Japan even merely flags a possible tweak down the road, much less an actual move to expand its yield-curve-control band this Friday, EURJPY could be set for a powerful move lower. We have a local bearish reversal here after Friday’s sharply rally has since been erased, but further technical evidence that this year’s bull market is coming unwound would require a close back below the 153.50 area pivot low from earlier this month. Bigger picture, the pair really needs to reverse out the bulk of the gains since 150 for a more emphatic signal that the extraordinary period of policy divergence is ending and we are headed in the direction of convergence for the next year or more.

25_07_2023_JJH_Update_01
Source: Bloomberg

China stimulus hopes boost Antipodeans

A Politburo meeting and accompanying statement have helped revive the commodity space, if somewhat modestly. The best proxy for Chinese stimulus hopes is perhaps copper, which turned sharply higher overnight and boosted the Aussie. We can believe something bigger is afoot here for the Aussie if copper can sustain a strong bid up through the 3.95-4.00/lb. area. So far, China’s stimulus signals have been too muted and hesitant thus far. The USDCNH rate was punched lower as a further sign of the Politburo meeting making waves overnight- still just looks like consolidation in that pair. See more on the policy signals from the meeting in Redmond’s excellent piece.

An important further test for the Aussie comes into view tonight as the Australia reports its Q2 CPI. The key “trimmed mean” core inflation figure is expected at 6.0% Y/Y, still unacceptably high, although the RBA is also priced to have already reached its peak policy rate for the cycle or perhaps ready to hike one last time this year.

Table: FX Board of G10 and CNH trend evolution and strength.

The CNH comeback is so far a neutralization by the PBOC of prior extensive weakness – would be surprised to see this blossom into something more significant. More interesting from here is whether the USD can pull back into bull market mode after the FOMC and PCE this Friday. And note the negative momentum jolt in EUR – more building there?

25_07_2023_JJH_Update_02
Source: Bloomberg and Saxo Group

Table: FX Board Trend Scoreboard for individual pairs.

EURNOK has sold off strongly and is testing its 200-day moving average, with oil supporting NOK at the moment. Some of the USD pairs are barely hanging on to their bear USD trends. NZDUSD has flipped back to negative, AUDUSD is on the cusp and GBPUSD is also teetering – a key week ahead for USD trend status.

25_07_2023_JJH_Update_03
Source: Bloomberg and Saxo Group

Upcoming Economic Data Highlights (all times GMT)

  • 1230 – US Philadelphia Fed Non-manufacturing activity
  • 1300 – US May S&P CoreLogic Home Price Index
  • 1400 – US Jul. Conference Board Consumer Confidence
  • 1400 – US Jul. Richmond Fed Manufacturing Index
  • 1700 – US Treasury to auction 5-year Notes
  • 0130 – Australia Q2 CPI

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