2 Potential Game-Changers for EUR/USD

DailyFX

An optimistic tone from the European Central Bank (ECB) this week would help to align US and Eurozone monetary policies, and if Friday’s NFP report disappoints, the EURUSD outlook could be notably altered.

The US dollar (USD) is trading lower against all major currencies this morning after the ISM report showed a contraction in manufacturing activity for the month of May.

Over the past few months, the primary driver of EURUSD weakness has been the divergence between US and Eurozone growth and monetary policies, and today’s downside surprise in US data and upside surprise in Eurozone data could contribute to shifting expectations this week.

While manufacturing reports are not game changers for the euro (EUR) or the dollar, they do reflect the overall performance of the respective economies and could affect the European Central Bank (ECB) monetary policy decision on Thursday.

The ISM manufacturing index, which dropped to 49.0 from 50.7 last month, indicated that manufacturing activity contracted at its fastest pace in four years. This is a bit of a headache for the Federal Reserve, but its primary focus remains the labor market, so Friday's non-farm payrolls (NFP) report will be the number-one US event risk this week.

If job growth is also disappointing and the tone of the European Central Bank is a bit more optimistic, the playing field could be altered, thereby affecting how the EURUSD trades.

Will the ECB Alter the Playing Field?

As seen in this morning's Eurozone manufacturing PMI numbers, economic data in Europe is beginning to improve. The manufacturing sector did not contract as much as initially reported in the month of May. The index was revised up from 48.8 to 48.3 (a 14-month high) with improvements seen in both Germany and France.

On Sunday, we heard some cautiously optimistic comments from ECB President Mario Draghi that were later confirmed by the PMI reports. Draghi said there are a "few signs of possible stabilization" in the Eurozone, and they expect a "very gradual recovery" later this year. With the central bank gearing up to meet this week, these comments could be Draghi's way of setting expectations for more a moderate and less-pessimistic outlook on Thursday.

When the ECB last met, it doled out a big dose of easing by cutting the main refinancing rate by 25 basis points (bps), the lending rate by 50 bps, and extending the fixed-rate allotment until July of next year. On top of that, the Bank said it was willing to consider negative deposit rates.

Draghi used the word “weaker” countless times in his introductory statement to describe the economy, and in addition, he said he was very worried about the labor market and warned that the weakness in growth expanded beyond the periphery to core Eurozone economies. His talk about stabilization and recovery on Sunday suggests that the central bank will not be nearly as grim, which could alter the playing field for the EUR.

Negative deposit rates are still on the table, but we feel that the economy needs to deteriorate more significantly, or European markets need to see additional volatility in order for the ECB to resort to this option. In the meantime, European and US investors are ignoring the ongoing deleveraging in Tokyo.

The Nikkei dropped another 3.7% overnight, putting total losses at 15% over the past two weeks. If the S&P 500 dropped 15%, everyone would be screaming that the bull market is over and stocks around the world would decline, but so far, we haven't seen much contagion, though we are worried that we may see it soon.

See related: Risk FX Rallies as USD/JPY Tiptoes Near 100

By Kathy Lien of BK Asset Management

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