Negative yields hit the euro

Market participants will be distracted by today’s US Presidential election and Thursday’s transfer of leadership in China. The USD seems to be enjoying strength despite a slight lead in the polls by President Obama. The consensus view is that a Romney win would be USD positive given that it may imply a more restrictive Fed in the form of less QE but the USD appears to be ignoring such polls.

The EUR is the worst performing currency so far this month after the CHF. Greek and Spanish concerns are placing a growing weight on the EUR the former due to tomorrow’s vote on austerity measures and the latter due to worsening economic data and a lack of traction towards requesting a bailout and thus activating the European Central Bank’s bond purchase program.

A massive weight on the EUR is the fact that Germany 2 year bond yields have turned negative, leading a widening US yield advantage and in turn a weaker EUR/USD. Indeed, the correlation between 2 year US – German yield differentials is very high, implying that the EUR will struggle below its 200 day moving average around 1.2828 until German yields push higher.

A generally firmer USD has also dealt a blow GBP, with the currency slipping below 1.6000. Notably GBP is holding up well against the EUR. Industrial and manufacturing production data today will give some direction to the currency but the news is unlikely to be positive, with a further sharp decline expected in September.

Thereafter attention will swiftly turn to the Bank of England policy decision on Thursday, where the decision will be a close call but we look for an additional GBP 25 billion in asset purchases to be announced. GBP could face some pressure in this event but given that the currency not been particularly impacted from QE in the past, we doubt that it will suffer a severe blow. However, the BoE action may help to stem the decline in EUR/GBP, with support seen around 0.7956.

AUD has lost some steam this week as speculative longs have been cut back ahead of the RBA policy decision. The pull back has largely to do with a generally firmer USD, some deterioration in risk appetite and lower commodity prices than any shift in policy expectations, however.

The market is pricing in around a 50% probability of a rate cut today Given that this is not fully priced in, the AUD is vulnerable in the wake of a rate cut. However, much will depend on the accompanying statement. Given that recent domestic and Chinese data have been a bit more encouraging we doubt that the statement will be particularly dovish, suggesting that downside risks to AUD will be limited to technical support around 1.0305 versus USD.

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