Draghi's Deflation Delirium Cannot Drown EUR

by: Dean Popplewell

The lack of forex trading suggests that investors are not convinced by either market direction. The current predominant trade has more to do with reducing risk – paring of open decisions – rather than initiating new positions. Both the ECB rate decision and rhetoric that follows tomorrow, along with Friday's "dirty data" employment numbers have the market obviously concerned. Investors require a clearer head and seek stronger conviction before taking on any further baggage at the moment. Let's hope by this Friday afternoon the market will have gotten a green light, otherwise the last six-weeks of the calendar - historically a trending period – is in danger of being a non-starter.

Draghi is "drowning" in deflation, while last month's U.S. partial government shutdown has yet to filter through on the job numbers front. At tomorrow's ECB rate announcement capital market players are expecting Draghi to be fairly dovish. The weakness in the EUR over the past week suggests that the market had already begun to position for that, either by cutting the EUR longs or initiating new EUR short positions. The question that many are trying to answer is whether "this" deep EUR loss witnessed is more than a corrective move in the dollar?

The eurozone's current deflation woes has prompted speculation that the ECB will invoke policies from a reduction in its benchmark lending rate (+0.5%), to adding fresh liquidity to the financial system, or broad-based asset purchases similar to those by the Bernanke's Fed this coming Thursday. The futures markets have since eased back on "pricing-in" the ECB to ease this week; however, a refi rate cut of -25bps is still expected at next month's meeting. Draghi will may have to follow the RBA's Stevens and talk the EUR's way out or down from the current situation.

Current euro data is not making euro policy makers' jobs any easier. Economic releases this morning indicate that the "zones'" retail sales fell in September (-0.6%, m/m) and that a recovery in the region's business activity has lost momentum (PMI eased to 51.9 from 52.2) at the start of this quarter. For sales, consumer spending remains fragile in the face of high regional unemployment and slow wage growth. This too is not a eurozone regional phenomena, it’s a global issue. The retail sales dip is obviously strong proof that consumer demand remains anemic – but is this enough of an immediate impetus to push the ECB into proactive policy territory? Or does the ECB stick to the reactive "long" game plan? The region's austerity programs have left the eurozone economy highly dependent on exports as a source of demand. The street's consensus is that the ECB will not make a move tomorrow, however, surprises are welcome.

The U.K. economy remains on a "hot streak." The strong U.K. data just keeps on coming as more numbers this morning show manufacturing production (+1.2%, m/m and +0.8%, y/y) and industrial output (+0.9%, m/m and +2.2%, y/y) both beating consensus. Yesterday, the European commission doubled its estimate for the U.K.'s economic growth for this year (+1.3%, y/y). Such predictions would make the U.K. the fastest growing of the main European economies. Tomorrow Governor Carney at the BoE gets to "show and tell" at the regular monetary policy meet – however the market expects no rate action from U.K. policy makers. Capital markets are more interested in the November inflation report, out on the 13th of this month. In its unemployment forecasts will lie the future of forward guidance, and therefore, policy settings. Investors are trying to figure out whether the U.K.'s QE is now officially buried. Currently, sterling remains invincible, plodding higher all week tripping weak stop-losses on the back of favorable data and an investor trying to "cap a top" – the pound moves stateside straddling a one-week high of 1.6107. A dollar reprieve may come in the form of an "Old Lady."

Employment numbers this week are not confined to the northern hemisphere. The Aussies get to report this evening while the Kiwis reported earlier this morning. New Zealand’s employment surged +1.2% q/q (Household Labor Force Survey-HLFS), against consensus of +0.5% and this after a couple of quarters of subdued growth. The unemployment rate dropped to +6.2%, despite a higher participation rate of +68.6% from +68.1% in Q2. For the NZD (0.8400), a stronger number had already been priced in; the currency price fluctuation has more to do with global dairy prices than the domestic current employment situation.

For now the stronger-than-expected U.S. ISM readings are likely to try and keep the world's reserve currency of choice somewhat supported against G10 and EM currencies for the time, until shown otherwise. The fixed income market believes that with U.S. tens' yield almost +20bp above the lows established ahead of the last FOMC meet that support for the dollar may run into some headwind, especially in the absence of new signs of strength from data. The market is anxious about Friday's NFP print - a soft payroll print could give the thumbs up for a USD retracement to begin.

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