ECB sends euro lower:

Just after 0930 EST this morning strong rhetoric out of the ECB sent the euro slicing below the the 1.3400 level. This time the euro can thank ECB Nowotny for this comment:

“Deflation bigger risk than inflation in near term”

Uh oh… after the euro failed to break the 1.3428 upside key level, its downside momentum was propelled by this alarming rhetoric from Nowotny. Of course it didn’t help the euro that Bernanke’s 1000 EST testimony sent the Dow and S&P 500 lower, which pushed the USD Index higher. As weak as the dollar is, ECB deflation rhetoric combined with equities losses pretty much stacks the odds against the euro and it can’t do anything but go down.

The timing of Nowotny’s deflation rhetoric isn’t coincidental. The latest Eurozone PPI printed at -0,7% which is worse than expected and points to further signs of disinflation. So, reading between the lines here, obviously if Nowotny and members of the ECB are concerned with deflation it definitely gives the green light to reduce interest rates on Thursday. Plus, if other voters on the 22-member ECB governing council share Nowotny’s views on deflation and disinflation, it also opens the door for the so-called ‘non-standard measures’ and certainly ups the probability the ECB reveals these non-standard measures on Thursday.

And how would a central bank fight deflation? By creating inflation and the best way to create inflation is by printing money, increasing the velocity of the money supply, and spiking the monetary base. And how would the ECB accomplish this? Either through qualitative and or quantitative easing in addition to decreasing the cost of money, loosening credit, and extending credit on more favorable terms to the borrower.

As we’ve talked about many times, deflation is one of the worst case scenarios for the ECB and something they will want to desperately avoid. So, between today’s ugly PPI data and the latest deflation rhetoric out of the ECB, I’m feeling more comfortable with the ECB hitting the markets with their own brand of ‘non-standard measures’ which will almost likely have the objective of ensuring inflation by using monetary policy.

And no matter how weak the dollar may be, the euro doesn’t stand a chance against deflation rhetoric from a central banker, it will be sold-off when a central banks starts throwing the ‘D’ word around, it can’t really go any other way.

Bernanke, the ‘Bob Ross’ of central bankers:

In the spirit of the great Bob Ross, Ben Bernanke painted happy little pictures of a happy little market bottom, a happy little economic recovery, and a happy little end to the recession. Wall St. didn’t exactly buy in to the theatrics in DC today, although I think the pullback we saw in the S&P 500 and Dow was more a function of price action and market behavior taking a breather after breaking key resistance levels and making a strong run to the upside. In addition, spot crude was on a weaker footing while the drop in the euro gave a boost to the USD Index and that scenario doesn’t help stocks anyway.

I don’t exactly agree with Bernanke’s assessment of overall economic conditions, although it’s hard to argue with him because the US fundamentals released the past 45-days have mostly printed to the upside and better than expected. I don’t trust government data anymore than I trust a Democrat or Republican, but whether or not the data is fudged, it’s all we have to work with and all the markets have to go on.

ISM services–

Here again we had a key piece of fundamental data print much better than expected, showing a strong month-over-month improvement of almost 3-points. After breaking the whole report down, I see that the business activity component increased by 1.1-points, new orders by 8.2-points, employment by 4.7-points, and prices by almost 1-point. Good signs? Absolutely. Now lets see if it can sustain into the summer session…

LIBOR… good for credit, bad for dollar:

As mentioned in the prior update, the 3-month US dollar LIBOR rate fell to an all-time record low of 0.986%. This historical low in USD LIBOR has several ramifications us currency traders need to consider. US dollar LIBOR is the world’s foremost and widest recognized benchmark interest rate banks charge each other to lend in US dollars. LIBOR rates are also closely connected to the Fed Funds target rate and the 10-year Treasury.

LIBOR is one of the core underlying fundamentals of the FX market that I really get excited about and here’s what the sub-1% dollar LIBOR rate signifies:

  • Conditions in credit markets are loosening and improving
  • Market participants are willing to take on risk
  • Banks are beginning to stop hoarding cash reserves and willing to lend
  • ‘Safe haven’ demand for the US dollar is waning
  • A good number of banks have de-leveraged or are well along in the process of de-leveraging
  • Money-flows are resisting low risk bonds in favor of higher risk markets and asset classes

And, this potential sign could be the best of all… if the 3-month dollar LIBOR rate trend, in addition to the 6-month and 9-month rates continue lower, combined with what’s happening on the USD Index, the dollar could be poised to take a royal beating and move into the realm as a funding currency, similar to the Japanese yen. This could really make for a nasty Q3 and or Q4 for the dollar if the credit markets continue down this road and that would be a dream come true.

In regards to the Fed Funds target rate, what we now need to watch for is the spread between the upper trading band of Fed Funds and the 3-month dollar LIBOR rate. Right now the spread is about 75bps, in other words, 3-month dollar LIBOR is still well above the highest rate of the Fed Funds target trading band of 0.00% to 0.25%. Back in the good ‘ole days when the S&P 500 and Dow were on an unstoppable run and the EUR, GBP, AUD, and NZD were beating the crap out of the USD and JPY, the 3-month dollar LIBOR rate averaged less than 25bps above the Fed Funds target rate. So, we’re not quite there yet, but we are getting there and these are all great signs, both for equities, credit and money markets, and higher-yielding currencies.

Wednesday trading:

Besides what we covered above, Tuesday was mostly a quiet day in the markets, but tomorrow will be a bigger day fundamentally.

Treasuries continue to remain bearish as the Fed auctions billions upon billions of new issuance this week. In sum, the Fed will auction $71 billion in notes and bonds this week. We still have a 10-year note and 30-year bond auction to get through and at this point, I have to believe the outcome will be less than desirable, keeping Treasuries on their bearish footing. The supply is staggering, especially for longer dated maturities.

Out of the Eurozone we get Services PMI and Retail Sales, but the big data of the day will be the Challenger Job Cuts and Crude Inventories data, and of course the ADP NFP which is one of the most worthless pieces of data on the face of the earth, but market participants watch and react to it, so keep an eye on that one. We also get central bank speeches from the SNB Jordan and Roth and Fed Yellen. Also, keep your eyes and ears out for the ECB as they continue to hit the markets with surprise rhetoric.

As far as trading goes, be mindful that the 24-hours ahead of the ECB and BOE rate events will bring continued times of book squaring and pre-positioning as market participants get settled in for these major fundamental calendar events. The positioning is what causes some of the sharp price swings we’ve seen this week, especially between 1730 EST and 2030 EST. Tokyo is still closed tonight and conditions will remain thin.

EUR/USD–

For the EUR/USD, here again, the euro will remain tightly correlated to the S&P 500, S&P 500 futures, and spot crude. The USD Index failed to make a move to the 83.50 level and has recovered as equities saw profit-taking and took a breather today. The euro’s upside/downside potential rests on how equities perform in relation to the USD Index, in addition to whatever rhetoric may come out of the ECB ahead of their monumental rate decision on Thursday, plain and simple. I don’t think a trader needs to be a bull or a bear as the euro’s market correlated variables are leading the way.

That being said, overall, I am not interested in buying the dollar or holding dollar-long positions, I still prefer selling the USD and JPY and will continue buying the dips (EUR/USD, EUR/JPY, GBP/JPY) when 30-minute price opens and price action behavior show downside moves are over-extended and exhausted.

As we draw closer to the big calendar events on Thursday and Friday strict risk and money management becomes even more imperative, so be smart with your entry size and leverage usage. Maintaining a usable margin level of 96% or better is a great way to stay out of trouble and mitigage bigger losses. Key levels will be posted in the morning .

-David