Euro, British Pound Selling May Accelerate As CPI Reports Stoke Deflation Fears (Euro

The Euro and the British Pound may see selling pressure accelerate as May consumer price index results bolster fears that Europe may slip into deflation. The June edition of Germany’s ZEW survey of investor sentiment is also on tap.

[U][B]Key Overnight Developments[/B][/U]

[B]• BOJ Keeps Rates at 0.10%, Upgrades Economic Forecast for 2nd Month
• RBA Meeting Minutes Hint Australia May Cut Rates Again This Year[/B]

Critical Levels[/B][/U]

The [B]Euro[/B] ended the overnight session little changed against the [B]US Dollar[/B] as prices retraced having tested as low as 1.3749 after stocks tumbled in Asian trading. The[B] British Pound[/B] bore the brunt US Dollar strength, slipping as much as -0.6% before recovering a bit ahead of the opening bell in Europe.

[B]Related Article[/B][B]s[/B]: British Pound / US Dollar: Sell Entry Opens as Candlesticks Point to Bearish Reversal

[U][B]Asia Session Highlights[/B]

The [B]Bank of Japan[/B] kept interest rates unchanged at 0.10% as was expected. Policymakers said that “economic conditions have began to stop worsening”, raising its economic forecast for the second consecutive month. That said, the BOJ continues to see downside risks to economic growth and said inflation may decline more than expected. Although Maasaki Shirakawa and company said “exports and production have begun to turn upward”, the dismal outlook for global trade volumes in 2009 and 2010 from the IMF suggests otherwise, arguing that a robust recovery for the export-dependent country will remain elusive for the time being, leaving output and employment levels at the lower end of the spectrum. Indeed, the current account surplus shrank more than expected in April as overseas sales tumbled -40.6%.

Minutes from the last meeting of the [B]Reserve Bank of Australia[/B] bolstered governor Glenn Stevens’ earlier comments suggesting policymakers may reduce interest rates again in the months ahead. While the RBA again asserted that the full effects of standing monetary and fiscal stimulus are yet to be fully reflected in the broad economy, the bank said the current inflation outlook “gives scope” for rate cuts if needed. Policymakers also acknowledged that the recent appreciation in the Australian Dollar have reduced the impact of stimulus measures.

[B]Euro Session: What to Expect[/B][/U]

The [B]UK Consumer Price Index[/B] report is expected to show that the annual pace of inflation to fell to 2.0% in the year to May, the lowest since September 2007. Although the reading is still within the Bank of England’s target parameters, continued economic weakness is likely to push price growth lower. Indeed, a survey of economists conducted by Bloomberg is calling for GDP to continue to shrink at least through the first quarter of next year, sending CPI below 1% by the third quarter of this year. The Bank of England has said that such extremes will be temporary, with prices recovering to 1.4% by the end of next March. However, these forecasts are based the assumption that the economy will grow 0.2% next year, a claim that is contested by the International Monetary Fund which expects the UK will shrink -0.4% in 2010. If the IMF outlook proves correct, prices could well drift into negative territory, threatening to substantially extend the current downturn as expectations of deflation encourage consumers and businesses to wait for the best possible bargain and perpetually hold off on spending and investment.

Turning to the continent, the [B]Euro Zone Consumer Prices Index[/B] is set to show that annual inflation came to a standstill in May having registered at a record-low 0.6% in the previous month. As we noted last week, the currency bloc now faces a credible deflationary threat, arguing for a far more forceful monetary response than anything that has been introduced by the European Central Bank thus far. Overnight index swaps suggest that traders are pricing in virtually no chance that the ECB will lower rates at the next policy meeting and quantitative easing will be difficult to expand beyond the modest measures announced earlier this month given the internal conflict about such policies within the central bank. This opens the door for traders to punish the Euro as they price in expectations that the region will substantial lag behind other industrial economies in seeing economic recovery, forcing interest rates to stay lower longer than elsewhere.

Separately, Germany’s [B]ZEW Survey [/B]of investor sentiment is expected to rise to 35.0 in June from 31.1 in the previous month, registering at the highest level in three years. However, improvements in the metric are unlikely to offer much near-term support to the single currency: the ZEW reflects the forward-looking perspective of the survey respondents, meaning the reading tends to lead the Euro by a significant margin such that the trend in the Expectations component inverts major tops and bottoms in the exchange rate. Specifically, the ZEW began to trend lower in the beginning of 2006 and bottomed out in July of last year; the same end-points mark the beginning of the last major uptrend in EURUSD that saw the pair test record highs above 1.60. If the same dynamic is to continue to hold, traders can expect the European unit to set a bottom as the ZEW tops out, a scenario that seems unlikely for the time being considering how much ground remains to be covered before the economy regains firm footing.

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