Euro Selling Possible as German Inflation Shrinks For the First Time in 23 Years (Eur

The Euro may see selling pressure ahead as preliminary estimates of Germany’s Consumer Price Index show that the annual inflation rate shrank for the first time in over two decades in June, threatening the Euro Zone’s largest economy and the region as a whole with the onset of deflation.

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

[B]• New Zealand’s Economy Shrank More than Forecast in First Quarter
• Japanese Annual Inflation Rate Falls Most in Seven Years in May
• US Dollar Lower as Stock Exchanges Advance in Asian Trading [/B]

[U][B]Critical Levels[/B][/U]

The[B] Euro[/B] advanced in overnight trading, adding 0.4% against the US Dollar to test as high as 1.4047. The[B] British Pound [/B]followed suit, testing as high as 1.6444. The greenback saw selling pressure as Asian stock exchanges gained on news that US GDP shrank less than expected in the first quarter.

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

New Zealand’s[B] Gross Domestic Product [/B]shrank more than economists expected in the first quarter to reveal the economy was contracting at an annual pace of -2.7%, the most in over three decades. The result marks that fifth consecutive quarter of negative growth for the smaller antipodean nation. Although RBNZ Governor Alan Bollard has said that economic growth will pick up by the end of this year and chose to leave interest rates unchanged at 2.5% earlier this month for the first time since June 2008, additional easing seems likely to jolt the economy back to life especially since the soaring public deficit has seen Prime Minister John Key’s government abandon a hefty portion of the fiscal stimulus measures that had been included in the latest budget. Bollard conceded that “modest” interest rate reductions may be on tap “in the coming quarters” and reiterated that policymakers “expect to keep [rates] at or below the current level through the latter part of 2010.” Still, overnight index swaps price in only a 22% probability of additional easing at the next RBNZ policy meeting in July and 50-75 basis points in tightening over the next 12 months.

In Japan, May’s[B] Consumer Price Index[/B] report revealed that inflation fell at an annual pace of -1.1%, the largest decline since April 2002 and just a hair off the record low at -1.6%. Deflation looks set become entrenched once more in the world’s second-largest economy, keeping a lid on a meaningful rebound in economic activity as consumers and businesses are encouraged to wait for the best possible bargain and perpetually delay spending and investment.

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

Preliminary estimates of Germany’s [B]Consumer Price Index [/B]are expected to show that the annual inflation rate fell to -0.1% in June, the first reading in negative territory in 23 years. We had noted the likelihood of such an outcome last week as Producer Prices were set to tumble to a similar low. The onset of deflation in the Euro Zone’s largest economy is all but certain to take region-wide inflation along the same trajectory, threatening to commit the currency bloc to a long-term period of subpar economic growth as consumers and businesses are encouraged to wait for the best possible bargain and perpetually delay spending and investment.

As we have argued previously, the present situation argues for a far more forceful monetary response than anything that has been introduced by the European Central Bank thus far, a view that is apparently shared by the OECD. Even so, recent comments from ECB officials have stressed that rates at 1% are “appropriate” for the time being and quantitative easing will be difficult to expand beyond the modest measures announced earlier this month given the internal conflict about the merit of such policies within the central bank. This opens the door for traders to punish the Euro in the weeks and months ahead as they price in expectations that the region will substantially lag behind other industrial economies in recovering from the current downturn, forcing interest rates to stay lower for longer than elsewhere.

In Switzerland, the [B]KOF Swiss Leading Indicator[/B] is expected to rebound to -1.75 in June from a record low at -1.86 recorded in April and May. The measure is a composite of six leading metrics from the industrial, retail and wholesale sectors and is designed to project the direction of economic growth in the coming six to nine months. The minor upswing implies that the economy will continue to shrink at least through 2009, albeit at a slightly slower pace. The Swiss National Bank has forecast that the economy could contract as much as 3% this year, the most since 1975.

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