With 24 hours to go before the EU Summit and headline risk to pressure currencies, the U.S. dollar is performing extremely well this morning. The greenback strengthened against all of the major currencies during the first half of the North American trading session and barring any major upside surprises in U.S. data later today, should hold onto its gains for most of the session. U.S. existing home sales are scheduled for release at 10am ET and this second tier report should have a limited impact on the greenback. The biggest story overnight was Fitch's decision to downgrade Japan's credit rating, leaving Bank of Japan officials with plenty to talk about at their monetary policy meeting. Although the Japanese feel that their economy is on the path to recovery, a deteriorating current account balance, weak fiscal position and an aging population that will only worsen these imbalances in the coming years, prompted a decision by Fitch decided to cut Japan's rating one notch to A+ from AA-. What makes this specific decision important is that in this specific case, Fitch is the trailblazer. They are the first to take the axe on Japan by dropping the country's rating below S&P and Moody's levels. Since S&P already has the country on negative outlook, we would not be surprised if they took a similar move. Although the downgrade provides yet another headache for the Japanese, they will be happy to see the Yen weaken but with risk aversion at such elevated levels, the downgrade will not be enough to carve out a bottom for USD/JPY.
Meanwhile pre EU Summit speculation has put the EUR/USD under pressure. Whether German Chancellor Angela Merkel likes it or not, Eurobonds and boosting the effectiveness of the EIB and deposit insurance for the region will be discussed. Like the G8 meeting, don't expect any policy decisions to be made at this informal event because the Germans and other EZ nations do not want to assume the risk of distressed nations without being able to control their bank regulation and public finances. Nonetheless, the world will be listening in closely for any hint of cooperation. If Merkel shows any willingness to compromise with Hollande, EUR/USD will rally but if they do nothing but butt heads at the Summit, EUR/USD will remain under pressure. We don't expect Germany to cave and for any decisions to be made before the formal EU Summit which will be held after the Greek elections in late June.
Finally, this is a big week for the U.K. and annualized pace of consumer price growth slowed from 3.5 to 3.0 percent last month even as CPI rose 0.6 percent on a monthly basis. Inflation is receding and at a faster pace than economists anticipated. With oil prices falling steeply in May, we expect this trend to continue. As a result, policymakers are beginning to shift course and retracting their views that inflation may exceed expectations. Tomorrow's BoE minutes could show Adam Posen once again voting in favor of more easing which would be constant with the IMF's calls for more stimulus from the central bank. This morning, the IMF warned that the dangers posed by the euro crisis to the UK economy are large and could lead to lasting damage caused by a persistently large output gap. They encouraged the Bank to ease further through Quantitative Easing or an interest rate cut. We don't think the BoE will take any action before Greece makes a decision about the euro but in the meantime, like the EUR, the GBP should remain under pressure.