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Euro Slips on Weaker PMI Reports

The euro is trading lower at the onset of European trading following a round of weaker PMI reports. According to the earliest releases of Manufacturing and Service sector data, slower global growth and a strong currency could finally be weighing on the Eurozone recovery.

The latest report on analyst and investor confidence showed increased pessimism about future conditions but more optimistic about current conditions. However judging from the PMI reports, we may finally be seeing the slowdown that analysts have feared. Although all of the PMI reports still reflect expansionary conditions in the service and manufacturing sectors, the pace of expansion has slowed. The Eurozone composite PMI index dropped from 56.2 to 53.8 in the month of August with the service sector activity index falling to 55.9 from 53.6. The expansion in the manufacturing sector also slowed by a similar degree with the index falling from 55.1 to 54.6. Manufacturing activity in France grew at a stronger pace, but both PMI reports showed a slower pace of growth in Germany. These softer reports signal the possibility of weaker business confidence and a softer German IFO report.

There were also fresh concerns about sovereign debt problems in Europe. Don't be so surprised as we have warned that the debt problems are like an annoying fungus that keeps growing back. The latest news is from Ireland. According to the Irish Examiner, Finance Minister Lenihan warned that the riskiest lenders to Anglo Irish Bank will soon be told that they will not get all of their money back. If you recall, it was not too long ago that Lenihan publicly denied the need for emergency funding from the IMF and EU. Even if this is true, if Anglo Irish Bank is unable to pay back all of its lenders, it will raise fresh concern about the country's need for assistance which would undoubtedly have a negative impact on the euro. Irish bond spreads have already widened on the news.

UR: BIGGEST BENEFICIARY OF DOLLAR WEAKNESS

The euro has been the biggest beneficiary of dollar weakness, rising close to 2 percent against the greenback since the FOMC’s monetary policy announcement. Over the past 24 hours, the currency pair has broken four big figures, reaching a high of 1.3440 in the process. While the bulk of the attention has centered on the Fed’s possible easing, investors celebrated a number of successful bond auctions from Portugal, Greece, Spain, and Ireland, which up to now has been on the ‘bailout watch list’ for some time. The news prompted even positive comments from Spanish PM José Luis Rodríguez Zapatero who believes “the debt crisis affecting Spain, and the euro zone in general, has passed.” Despite the much needed good news, July Industrial New Orders hit its lowest mark in 19 months, dropping by twice as much the forecasted 1.2 percent estimate to print -2.4 percent. This marks the first major decline after 5 months of unsteady gains in the value of products and services to be delivered to European manufacturers, signaling not only a lack of demand in Europe’s stunted manufacturing sector but a sharp decline in expectations as well. Consumer Confidence also fell (albeit at a slower pace over the recent months) below the forecasted -10 value to match last month’s -11, revealing to the market that while pessimism about the economy is declining, real activity is failing to keep up with outlook for the region. As many of the euro zone member nations pursue economic reform and fiscal austerity plans, tremendous budget deficits and the continued weakness is making it quite difficult for the region to face broader issues such as the crippling 10.00 percent unemployment rate and growth going forward. Looking ahead, we have a number of key PMI releases on Thursday from both France and Germany, while the IFO Business Climate index on Friday brings the week to an end.

Dollar: Prone to More Weakness

Although the dollar rose significantly against the euro after the central bank decided to reinvest the principal payments from agency and mortgage backed securities, it should not perform as well this time around. U.S. yields have fallen sharply following the FOMC announcement which has and will continue to weigh on the U.S. dollar. The Bank of Japan’s commitment to intervention may be tested once again if usd/jpy falls below 84, which appears very likely given current conditions. The Federal Reserve left interest rates unchanged at 0.25 percent. The last time that the central bank changed interest rates was in December 2008 when they brought rates down from 1 percent to current levels. Their concern about deflation and their willingness to further ease monetary policy drove the U.S. dollar sharply lower against all of the major currencies. Although the Fed’s assessment of the economy remained mostly unchanged, their emphasis on inflation being below the level consistent with their mandate indicates that the feeble recovery is not the only reason why the Fed could inject additional stimulus into the U.S. economy. By saying that they are prepared to provide additional accommodation if needed to support the economic recovery AND to return inflation to levels consistent with its mandate, the central bank is essentially telling us that are a number of reasons why the balance sheet may be expanded in November. The Fed stopped short of using these specific words, but their warning of additional stimulus clearly reveals their thinking. Even if the central bank does not follow through with more QE, there is no question that they are one of only a handful of central banks looking to ease and not normalize monetary policy. As a result, the dollar has been sold aggressively and will probably under pressure for the rest of the week.

With six weeks to go before the next FOMC meeting, the Fed still wants to see if the economy improves before activating their asset purchases. However at the end of the day, the tone of the FOMC statement is not all that surprising considering the central bank’s pessimistic growth and inflation forecasts. The U.S. central bank firmly believes that the pace of recovery will slow dramatically over the next few quarters, with unemployment remaining at very high levels and inflationary pressures nonexistent. The Fed could wait until deterioration occurs before taking action, but if they want to preempt the potential slowdown, it may be smarter to act before it materializes because when it does, it will be more difficult to fix. Since the last monetary policy meeting, the U.S. economy has not gotten much better or much worse which is the Fed held back from announcing asset purchases today. This morning’s housing market numbers provide hope that one of the most troubled sectors in the U.S. economy is finally stabilizing. Although whether next month’s retail sales and consumer spending reports will affect the Fed’s decision to start asset purchases in November, at this time it appears to be a done deal.