Black clouds threaten Europe’s recovery, taking the pressure off the USD

The market is still digesting the latest Fed decision this morning, as European equities follow their Asian and US peers lower. Although October’s Fed statement did not differ by that much compared with the statement in September, the Fed delivered a powerful punch: 1, it did not rule out the prospect of tapering in December, 2, the Fed won’t be swayed by what’s going on in Washington, and seemed fairly happy with the underlying pace of growth even in the midst of fiscal retrenchment.

This was not dovish enough for this market, causing stocks to fall and yields and the greenback to rise. This was further evidence that the market has a dangerous reliance on largesse from the Fed - how can record highs in the S&P 500 be sustained into year-end if there is the slightest suspicion that the Fed could start to scale back its QE programme in December?

The Fed versus the Market

Interestingly, the Fed and the market are still interpreting the Fed’s tapering programme in opposite ways. The Fed does not believe tapering equals tightening, reiterating that whatever happens to asset purchases the Fed will still have a “highly accommodative stance of monetary policy” because interest rates will remain exceptionally low for a prolonged period. However, the market sees things slightly differently, and ignored this dovish impulse from the Fed, which triggered a sharp rise in Treasury yields from 2.47% to 2.54% in the 10-year government bond. Stocks also came under pressure and the S&P 500 fell 0.5%.

So what about the dollar? The Fed statement added fuel to a mini-dollar rally that started earlier this week, and after basing at 78.99 on Monday, the dollar index is currently skimming the 80.00 zone, the highest level in 2 weeks. However, dollar strength has not been broad based, and on Thursday it has given up gains versus the JPY, AUD, CAD and NZD.

USDJPY rose to a high of 98.68, however, the BOJ meeting earlier today, which also kept policy on hold and made no mention of fresh stimulus, weighed on this cross, which is back to the prior range high of 98.20. Watch for initial jobless claims and then next week’s payrolls to get more direction on this cross.

Eurozone recovery hits a road block

EURUSD is slightly more interesting in our view especially after some dismal economic data out of the currency bloc. The September unemployment rate surged to a record high of 12.2%. This is concerning, because the jobless rate spiked after the summer, suggesting that job growth in some of the hardest hit peripheral economies could be seasonal rather than a permanent sign of strength in the labour market.

Perhaps the scariest number for the ECB was the sharp drop in inflation this month. CPI fell to 0.7% from 1.1% in September, which is the lowest level for 4 years. This may be too close to deflation territory for the ECB to bear. We may find out at the ECB meeting next week if the drop in prices and rise in the jobless rate has given the Bank some wiggle room to loosen policy. Austrian central bank head Nowotny hinted that the ECB is willing to replace expiring LTRO loans with more liquidity, saying “what is clear is that there will be liquidity provision.” However, after today’s dreadful data, could the Eurozone economy do with something a bit more powerful from the ECB?

The focus shifts to Europe’s problems.

This will be on the market’s mind as we lead up to next week’s ECB meeting, and we think that the market could be a bit wary of holding EUR into next week’s meeting. Thus, going forward the focus may shift from the dollar and the US’s economic and fiscal problems to the on-going growth concerns in the Eurozone, and the fact that the green shoots of recovery from earlier this year could be starting to wilt.

Technical outlook EURUSD

From a technical perspective, EURUSD had already fallen back from 1.3780 highs after the not-so-dovish Fed statement. After finding some support around 1.3740 it drifted lower all morning, until getting a sharp nudge downwards post the double whammy of bad economic news for the currency bloc. So where could it go next?

In the short term, EURUSD is starting to look oversold, the hourly chart is below 30.00, so we could see some short term consolidation around 1.3660 – 1.3680. However, any move back towards 1.3700 may be faded by the market. On the downside, key support lies at 1.3650 – Kijun line on the chart and the low from 21st October. Below here opens the way to 1.3550 then to 1.3475 – he low from 16th October.