Weaker Data Adds Pressure on ECB to Act

Weaker Data Adds Pressure on ECB to Act
GBP: Lifted by Rebound in Manufacturing Activity
AUD: What to Expect from RBA
NZD: Resumes Its Slide
CAD: Quiet Holiday Trading
JPY: World Troubles and Yen Strength Weigh on Japan's Economy

EUR: Weaker Data Adds Pressure on ECB to Act

With the markets in the U.S. and Canada closed for Labor Day, it was extremely quiet in the FX market. The only burst of activity was seen between 10:30AM and 11:15AM ET. The rally was triggered by reports of ECB President Draghi telling the EU Parliament that purchases of sovereign bonds up to 3 years in maturity is not considered state aid.

More rumors of what the ECB could do as the crisis deepens helped more than it has hurt the euro. The European Central Bank's monetary policy meeting is the most important event risk this week and everyone from economists to traders expects the ECB to take additional steps to support the Eurozone economy. More specifically, the market is calling for a 25bp rate cut from the central bank.

The downward revision to August manufacturing PMI numbers illustrates the weakness in the Eurozone economy. Manufacturing activity slowed more significantly last month with particular weakness in Germany and France, the Eurozone's 2 largest economies.

Based on recent economic reports alone, the case could be made for a quarter point rate cut. However, that's not the only thing that investors are looking for the ECB to do. When the central bank last met in August, Draghi promised to create a framework for new bond purchases. The market is looking for the ECB to provide details on this framework at their monetary policy with the first purchases expected to be made in Portuguese bonds.

The central bank will also release its latest forecasts and unfortunately their GDP estimates are expected to be revised lower. The hope for more action from the ECB this week could keep the euro supported but if the central bank disappoints and leaves investors wanting for more, the reversal in the EUR/USD could be sharp and violent. There will be a lot more to talk about the euro and what the central bank could do as the week progresses.

Meanwhile, there have been a few pieces of Swiss economic data that has captured the market's attention. Despite the central bank's efforts at keeping the franc capped, Switzerland's economy continues to struggle according to the latest economic reports. Manufacturing activity contracted for the fifth consecutive month in August according to the PMI report while retail sales grew by 3.2 percent in July, down from 3.3 percent in July. Second quarter GDP numbers are due for release today, Tuesda,y and thankfully, growth is expected to increase following stronger retail sales and trade figures between April and June.

GBP: Lifted by Rebound in Manufacturing Activity

The British pound traded higher against the U.S. dollar yesterday, following better than expected manufacturing PMI numbers. According to the latest report from the U.K., manufacturing activity is beginning to stabilize.

The PMI index jumped from 45.2 to 49.5 in the month of August. Since the 50 level is neutral, the rise in the index reflects a sharp improvement in manufacturing conditions. This increase came as a big surprise after a similar survey released by the Confederation of British Industry showed a sharp deterioration in manufacturing activity last month. Nonetheless the upside surprise proved to be very positive for the pound.

According to Markit Economics, the agency that releases the report, output rose solidly at consumer goods producers while intermediate goods companies saw a marginal return to growth. The latest manufacturing data is encouraging but even the Senior Economist at Markit warns that the improvement in August "do little to change the underlying picture of a fragile sector facing enormous headwinds."

It's a busy week in the U.K. with PMI services, construction, industrial production and producer prices scheduled for release. The Bank of England will also be holding a monetary policy meeting but it should be the least interesting rate announcement this week because the BoE is expected to keep policy completely unchanged which means no details will be provided until the minutes are released 2 weeks later.

AUD: What to Expect from the RBA

The Australian and New Zealand dollars resumed their slide against the U.S. dollar ahead of the Reserve Bank of Australia rate decision. The surprise 0.8 percent decline in retail sales and drop in Chinese manufacturing activity according to HSBC raised concerns that the RBA could set the stage for easier monetary policy this year.

While the labor market has improved in Australia, consumer confidence and consumer spending remained weak. The real problem is the recent drop in iron ore prices which could hurt the profitability of many Australian companies and in turn, the overall economy.

Over the past 3 months, the price of iron ore has fallen more than 30 percent to a 3 year low and unfortunately iron ore is very important, accounting for more than 20 percent of total export values last year. The decline in iron prices is caused by slower growth in China, which is a double blow for Australia because China takes 25 percent of Australia's exports of which 60 percent is iron ore.

While manufacturing activity contracted at a slower pace in August (the PMI index rose 5 points to 45.3), the drop in iron ore prices poses a major threat to companies such as BHP Billiton (BHP), Rio Tinto (RIO), and Fortescue Metals Group (FMG.AX). Analysts predict that if the iron ore price stayed at current levels, BHP's earnings would be 23 per cent lower than expected, Rio's 41 per cent lower, and Fortescue would fail to make a profit. Weaker profitability for some of Australia's most important companies could temper the RBA's rosy outlook.

While we do not expect another rate cut from the central bank today, we anticipate less optimism and greater caution, which could take the AUD/USD below 1.02. With this in mind, there is still the possibility of a neutral statement from the central bank as it would not be the first time the RBA has turned a blind eye to weaker data. The central bank could take the view that their recent rate cuts haven't fully filtered through the economy and should continue to lend support for business and consumer demand.

The possibility of easier monetary policy from the European Central Bank or the Federal Reserve later this month could also encourage the RBA to wait another month before setting the stage for further rate cuts. If there is one thing the RBA has, it's the luxury of time because they have already eased aggressively this year.

The recent decline in the Australian dollar exchange rate from 1.06 to 1.0250 gives the central bank additional breathing room. If the RBA indicates that they remain comfortable with the current level of monetary policy, the Australian dollar could rise back above 1.0350. Meanwhile with U.S. and Canadian markets closed for Labor day, the Canadian dollar held steady against the greenback.

JPY: World Troubles and Yen Strength Weigh on Japan's Economy

The Japanese yen held steady or traded higher against all of the major currencies. No major economic data was released from Japan overnight Monday, but it was a busy evening for China and disappointing Chinese data weighed on overall risk appetite. The only piece of Japanese data released overnight was capital spending, which rose a mere 7.7 percent in the second quarter compared to a forecast for 8.9 percent growth.

The strength of the yen poses a continual threat to Japan's economy and last week the Japanese government downgraded the assessment for its economy for the first time in 10 months. While this is a quiet week for Japanese data, it won't be a quiet week for the yen, which will trade almost exclusively on risk appetite.

The Japanese government is intimately aware of the fact that they have zero control on the path of the yen. They can intervene to stem the currency's rise but if the source of yen demand comes from the desire for safety due to the mishandling of the European crisis, their intervention efforts will most likely prove to be futile and only slow the Yen's rise.

Unfortunately Japan is at the whim of the global economic developments and based on the disappointing pullback in industrial production last week, recent data from other parts of the world and yen strength, Japan could be poised for a contraction this quarter.