Next 24 Hours Are Euro Critical

For the first time in three weeks, EUR/USD tested and closed below the 1.30 level. The break of 1.3060 was technically significant with the currency pair barely looking back as it dropped to its next support level of 1.30. However with the euro failing to break below this level in a meaningful way, many traders are wondering whether it will hold. With a number of FOMC voters speaking Thursday and a busy euro-zone and U.S. calendar, the next 24 hours will critical for the euro. A large part of the sell-off in the EUR/USD from its high of 1.34 on June 19 to its low of 1.2985 Wednesday was driven by re-pricing of FOMC expectations, which means Thursday's speeches by FOMC voters Dudley and Powell are extremely important. All three of these members lean towards a more dovish monetary policy stance and if they support Bernanke's view that asset purchases should be tapered this year, the EUR/USD could drop to its next level of support at 1.2935 and then possibly to 1.28 (although we feel that losses should be contained to that level). However if any of these two FOMC voters express skepticism or reservations about Bernanke's timing on reducing asset purchases, the EUR/USD could make its way back up to 1.31.

German unemployment and euro-zone confidence numbers are also scheduled for release Thursday and the outcome of these reports will impact the market's expectations for ECB policy and in turn the euro. If the data is good, then the central bank's threat to increase stimulus will fall on deaf ears. Just this morning ECB President Draghi reminded everyone that the central bank stands ready to act if necessary. Unfortunately based on the latest PMI numbers, labor market conditions most likely deteriorated in the month of June and if the data is weak, confirming that ECB policy will trail far behind the Fed, the euro could find itself trading closer to 1.29. In terms of confidence, it will be tough call since there has been both strength and weakness in the latest IFO and ZEW surveys. These numbers shouldn't be as important as German unemployment.

Dollar: Hit From GDP Short-lived
The mixed performance of the U.S. dollar Wednesday was a sign of exhaustion in the FX market. The currencies that have seen the greatest losses in recent weeks (AUD, NZD and CAD) rebounded while the currencies whose losses were more limited (EUR, GBP and CHF) extended their slide. In other words, European currencies declined while the commodity currencies enjoyed a relief rally. The shockingly large downward revision to first quarter GDP growth had only a temporary impact on the greenback. The U.S. economy was initially estimated to have grown by 2.4% in the first three months of the year but due to a 0.8% overestimation of personal consumption, Q1 GDP growth was revised down to 1.8%. Personal consumption in particular grew only 2.6% compared to an initial estimate of 3.4%. While GDP numbers are very backwards looking, this revision is large enough to raise concerns that Bernanke is looking to reduce asset purchases prematurely. Given how he has looked beyond the increase in the unemployment rate in May, we feel that the Fed will also downplay the reduction in GDP estimates and move forward with their plan to taper this year. While the focus Thursday will be on Fed speeches, personal income, personal spending and jobless claims are also scheduled for release along with pending home sales. Personal spending is expected to increase with retail sales rising last month but not much is expected from personal income as average hourly earnings stagnated in the month of May.

GBP: Releases Financial Stability Report
The British pound sold off sharply against all of the major currencies Wednesday. The Bank of England released its bi-annual Financial Stability Report recommending Bank staff to provide an assessment of the "vulnerability of borrowers and financial institutions to sharp upward movements in long-term interest rates and credit spreads in the current low interest rate environment." The BoE warned lenders about the potential for a sudden increase in long-term interest rates and asked banks to raise additional capital. The BoE also cautioned that some borrowers are highly in debt, which could result in a loss for lenders. The Financial Policy Committee will be handling these reports and they demanded major banks raise 13.7 billion pounds of extra capital last week. The FPC also told banks to hold more than 100% of the requirement of liquid asset because "the impact of looser liquidity requirements on credit conditions is uncertain." In attempt to reduce the soaring current account deficit and boost growth, the UK government announced a new round of spending cuts and plans to raise 11.5 billion pounds in savings from government bonds. Chancellor of the Exchequer George Osbourne said during the Spending Review that by boosting the austerity program the government plans to lift its status from "rescue to recovery." Osbourne warned that although the government reduced its debt by a third it still remains high and "need to take tough decisions to deal with our debts."

AUD: Lifted By Continued Decline In SHIBOR Rates
The Australian, New Zealand and Canadian dollars ended the day slightly higher against the greenback. The 20bp decline in the overnight SHIBOR rate eased tensions and uncertainty in Asia, helping to lift commodity currencies in the process. Having hit a high of 13.44% last week, overnight lending rates in China have fallen from the stratosphere down to a more reasonable level of 5.55%. This decline eased concerns about holding AUD and NZD with demand further supported by the leadership change in Australia. The country's first female Prime Minister was ousted by Kevin Rudd, the man she replaced in a closed door Labor Party vote. Julia Gillard will now formally asks the country's governor general to make Mr. Rudd prime minister. While the markets have received Rudd's victory positively, the overall impact on the economy should be limited because the Labor Party is languishing significantly in the polls ahead of the September general elections. Treasurer and Deputy Prime Minister Wayne Swan also stepped down and will be replaced with Transport Minister Anthony Albanese. Australian politics will continue to dominate the headlines down under but our focus will be on Chinese money markets. New Zealand trade numbers are scheduled for release and given the sharp improvement in business PMI, the country's surplus is expected to improve.

JPY: Watch MoF Data And Nikkei
With no Japanese economic data on the calendar, the performance of the Yen was mixed. USD/JPY consolidated for the fourth consecutive trading day while the other yen pairs moved in different directions. EUR/JPY and GBP/JPY extended lower while AUD/JPY, NZD/JPY and CAD/JPY trickled higher. None of the moves in any of these pairs were significant enough to drive a break of recent ranges. Unfortunately there wasn't much on the Japanese calendar Wednesday night. The Ministry of Finance's weekly portfolio flow report is scheduled for release. The Japanese have been net sellers of foreign bonds for the past five weeks and even though U.S. 10-year Treasury yields breached 2.5%, the trend is not expected to change. However when it does, it could provide sufficient catalyst to renew the rally in USD/JPY and drive the currency pair back above 100. The recent decline in the Nikkei also prevented USD/JPY from rallying. Yen traders should watch this index carefully as a recovery could help to lift the pair.

Kathy Lien, Managing Director of FX Strategy for BK Asset Management.