Euro: All Eyes On Fitch's Take On Italy

By Kathy Lien, Managing Director of FX Strategy for BK Asset Management.

The U.S. dollar rebounded against all of the major currencies Thursday with the exception of the Japanese yen and its underperformance tells us that the dollar was driven higher by a reduction in risk. We can identify at least 3 reasons for the dollar’s decline on Thursday. First and foremost, stocks have retreated from their highs after hitting record-breaking levels every day this week and the sell-off prompted a recovery in the dollar. All of the good news this week encouraged investors to take on risk but with stocks retreating, currencies like euro, sterling and the Canadian dollar also came off their highs. One of the main reasons for the pullback in equities and currencies is end-of-month profit taking but President Trump’s threat to withdraw from the WTO also did not help. Thirdly, while Thursday morning’s U.S. economic reports were mixed, data from other parts of the world were unambiguously disappointing, leading to weakness for those currencies. Friday won’t be about data even though the Chicago PMI report and revisions to the University of Michigan’s Consumer Sentiment index are due for release. Month-end flows and updates on Brexit negotiations and Canada-US trade talks will drive currency movements. USD/JPY gave up all of Wednesday’s gains on Thursday but it needs to close firmly below 111.00 to usher in a new wave of dollar weakness. Unlike some of the other major currencies, the slide in USD/JPY will be limited by the prospect of Fed tightening.

The dollar could continue to rise against the euro. We’ve been talking about Italian bond yields all week and believe that Wednesday’s pullback was unjustified. Italian yields shot up on Thursday to fresh 4-year highs, driving the spread between Italian and German bond yields to their widest level in 5 years. Italy is the biggest problem for the euro right now and Fitch is scheduled to update its rating for Italy on Friday. Based on comments published in a local newspaper, the chance of some type of negative change (either in Fitch's outlook or rating) is very likely. Fitch said reforms in Italy are increasingly difficult and its planned spending could raise debt. If Fitch downgrades Italy, EUR/USD could hit 1.1550 on the fear that S&P and Moody’s will do the same when they update their ratings in October. This possibility alone encouraged profit taking in the EUR/USD after the 4-cent rise this month. Aside from the jump in Italian yields, Eurozone data was also weaker with confidence falling and consumer price growth in Germany easing.

Sterling, on the other hand, should continue to outperform and will be an attractive long near 1.2950. UK mortgage approvals were lower than expected but the dollar’s recovery is the primary reason for the currency’s slide. Also, EU Chief Brexit negotiator Barnier toned down expectations for a deal by saying that “no deal” is still possible. In an interview with a German radio station Thursday, he suggested that the possibility of an unprecedented deal is nothing new – they “were willing to form a strong relationship in the beginning” and that it was unprecedented because it went beyond trade and incorporated cooperation on security, foreign policy and aviation. We still think the EU’s willingness to work with the UK to reach an agreement by November is growing but Barnier’s comments today were enough of a reason for GBP/USD to reject rather than break the 50-day SMA at 1.3040.

The Canadian dollar sold off sharply on the back of a softer-than-expected GDP report. Growth stagnated in June, causing the year-over-year rate to slip from 2.7% to 2.4%. On a quarterly basis, economic activity accelerated but not as much as economists anticipated. These aren’t terrible numbers but with the U.S. and Canada saying nothing more than the talks are going well, investors are getting tired of waiting. We still think that Canada has no choice but to agree to a deal and expect USD/CAD to head back toward 1.29. Meanwhile, Thursday's worst-performing currency was the New Zealand dollar, which fell sharply on the back of lower building permits and business confidence. The 1% slide took NZD/USD below its 20-day SMA and puts the pair at risk of dropping under 66 cents. The Australian dollar also fell sharply as the softer private capital expenditures and building approvals put additional pressure on the currency.