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The Euro may see selling pressure emerge in the coming session as the Euro Zone Consumer Price Index shows that inflation fell for the second consecutive month in July, stoking risks of deflation that could commit the currency bloc to a long-term period of economic stagnation.

Key Overnight Developments

• Japan's Jobless Rate Higher Than Expected, Hits Highest in 6 Years
• Australian Lending Gains Least Since September 1993, Threatening Recovery
• Japanese Inflation Shrinks Most in Over Three Decades, More Losses Likely
• PMI Shows Japanese Manufacturing Expanded for the First in 17 Months
• US Dollar Retreats as Asian Stocks Rally After Sony Corp Earnings Outperform


Critical Levels


7-31-09

The Euro gained 0.4% in the overnight session while the British Pound added 0.3% against the US Dollar. Both currencies advanced as the greenback came under pressure amid a rebound in risk appetite that drove Asian stock markets higher following a better-than-expected earnings report from Sony Corp., trimming demand for safety-linked assets.


Asia Session Highlights

Japan's Consumer Price Index printed squarely in line with expectations in June, showing that annual inflation shrank at an annual pace of -1.8%, the most in at least 33 years. The Bank of Japan has reinforced expectations of negative price growth, noting that the pace of consumer price growth is likely to turn negative, reflecting the declines in the prices of petroleum products, stabilization of food prices, and overall economic weakness. Indeed, utilities and fresh food prices led declines, slipping -5.9% and -4.7% from the previous year. The operative question going forward is whether the BOJ's aggressive monetary easing measures will make CPI's dip into negative territory a temporary affair, or if deflation once again becomes entrenched in the world's second-largest economy. This would substantially delay any hopes for a recovery in the near term, keeping a lid on economic activity as consumers and businesses are encouraged to wait for the best possible bargain and perpetually delay spending and investment.

Turning the labor market, Japan's Jobless Rate jumped to 5.4% in June, the highest in 6 years, while the ratio of available jobs to seeking applications fell to 0.43, a new record low. Looking ahead, a survey of economists conducted by Bloomberg suggests the jobless rate surpassed 5% in the second quarter and will approach the 6% mark by the second half of 2010 while the Bank of Japan has said that consumption to remain weak as the employment and income situation [is] likely to become increasingly severe. This points to continued weakness in consumer spending as layoffs weigh on disposable incomes, a clearly on display in June's Trade Balance and Retail Sales data. Although Nomura/JMMA Manufacturing PMI rose to 50.4 in July to mark the first time since February of last year that the sector has expanded, the improvement is unlikely to boost hiring, with industrial output gains linked to restocking of inventories rather than sustainable growth in underlying demand.

In Australia, Private Sector Credit grew at the slowest pace in nearly 16 years, adding 3.4% in the year to June. Continued contraction in lending seems to bolster the central bank's recent assertion that the influence of changes in benchmark interest rates on bank lending rates has weakened over the past two years, suggesting monetary policy is losing potency in stimulating economic activity. A breakdown in this dynamic could prove to derail an extension of positive momentum that the Australian economy has built up in recent months of the back of generous fiscal stimulus, with growth levels retreating once again when the flow of government cash dries up.

Euro Session: What to Expect

The Euro Zone Consumer Price Index is set to show inflation fell for the second consecutive month in July, shrinking at an annual pace of -0.4%. Acute economic weakness is likely to keep prices under firm downward pressure in the months ahead. Indeed, the Euro Zone Unemployment Rate is set to rise to the highest level in over a decade at 9.7% in June, weighing on incomes and discouraging consumption, the largest contributor to GDP growth. The IMF recently forecast that the Euro Zone will stand apart from other industrialized economies in seeing GDP continue to shrink in 2010. If this dynamic sees expectations of falling prices become entrenched, the currency bloc may be facing a long-term period of stagnation as consumers and businesses are encouraged to wait for the best possible bargain and perpetually delay spending and investment.

The European Central Bank has seemingly struggled to formulate an effective policy response to the deflationary threat thus far. Jean-Claude Trichet and company have focused on banks as the vehicle through which to make money cheaper and put a floor under falling prices, promising unlimited lending to the region's financial institutions including an unprecedented 442 billion euro in 12-month bank loans. The ECB will also implement a 60 billion bond-buying scheme. To the central bank's credit, borrowing costs have indeed moved lower: although the ECB publicly maintains target interest rates at 1%, it has allowed the average cost of overnight lending (referred to as EONIA) to drift far below that. Indeed, borrowing in Euros has been consistently cheaper than doing so in British Pounds since late June, even though the Bank of England's stated interest rates are substantially lower at 0.5%. However, the lower cost of credit between banks has not translated into lending, and so has offered little stimulus to the overall economy. Indeed, loans to Euro Zone businesses and households grew just 1.5% in June, the lowest since records began in 1991. Banks may be choosing to hang on to cash as a buffer against $1.1 trillion in as yet unrealized losses linked to the subprime mess, according to the IMF, as well as the fallout from looming defaults and/or devaluations among the EU's newly-minted central European members. In any case, the door is open for traders to punish the Euro as the ECB's inability to ensure that looser monetary conditions translate beyond the interbank market make deflation all but certain.

In Switzerland, the KOF Leading Indicator that aims to forecast GDP growth in the coming 6-9 months is expected to print at -1.45 in July, extending a rebound from the record low in April. As with most industrialized countries, the mountain nation is showing tentative signs of stabilization after the GDP shrank the most in 15 years in the first quarter. Although the metric is still in deeply in negative territory and virtually assures that the economy will suffer profound losses through 2009, the cautious moderation seen over recent months suggests that a bottom may be forming. Still, deflation remains a threat to sustainable long-term growth with consumer prices falling for four months straight since March.

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