Runaway euro crushes Australian dollar

EUR: Pushback against higher yields continues as recovery strengthens

It has been another quiet trading session overnight with the dollar continuing to grind lower. The euro has been trading within a narrow range between 1.2150 and 1.2250over the past week. The next key resistance level is the year to date high from 6th January at just below 1.2350. The euro is continuing to derive support from the improving cyclical outlook in the euro-zone. The release of the PMI surveys at the end of last week revealed the recovery in the euro-zone economy continued to gather upward momentum. The composite index rose for the third consecutive month to a three year high of 56.9 in May. The improvement was mainly driven by the services component which climbed to 55.1 in May from 50.5 in April which was the highest reading since the star of the pandemic. It reflects the gradual re-opening of economies with notable upside surprises in both France and Germany. At the same time, the manufacturing component remained even more buoyant at 62.8 in May. New order growth was the highest since 2006. Businesses expectations were at all-time highs in anticipation that the faster pace of vaccine roll out will allow the eurozone economy to continue re-opening more fully heading into the summer. It supports our view that the euro-zone economy has now come out of recession and will begin to rebound more strongly from Q2 onwards.

However, it has been notable that long-term euro-zone government bond yields have dropped back since late last week. The 10-year German Bund yield has fallen backto-0.14% from a peak late last week at-0.07%. Similarly, the 10-year Italian government bond yield has fallen back to 1.02% from a peak late last week of 1.16%.It follows comments on Friday from ECB President Lagarde in which she reiterated again that the ECB are “closely monitoring” bond yields. It has signalled to market participants that the ECB are uncomfortable over the recent rise in bond yields which has dampened expectations that they will announce a slowdown in the pace of QE purchases at their next meeting on 10th June. It poses clear risks to our view that the ECB will step back from a “significantly higher” pace of purchases in Q3. We had assumed that the improving growth outlook and still loose financing conditions would encourage a mini-taper. The ECB though still appears concerned by higher yields at the current juncture. Recent price action in the euro should be less concerning. TheECB’s trade-weighted euro (EER-42) is largely unchanged (+0.2%) since their last meeting on 22nd May although it has risen more (+1.8%)against the US dollar which has weakened more broadly. If the ECB decides to maintain a faster pace of QE purchases at the June meeting, it should help to dampen the risk of a sharper move higher for EUR/USD in the near-term.

The ECB has made that mistake before. Probably not again.

So, for now, my risk case of Europe rebounding faster than China is slowing is playing out, lifting EUR in the short term and allowing DXY to deflate some more. China is doing the world a favour by crushing commodity inflation such that easy Fed money can go somewhere more constructive (or, at least, less damaging) which is killing off any AUD surge.

We’re at some pretty critical DXY support levels in the high-80s ahead so this could get interesting in the weeks ahead.