EUR/USD seems content to stay close to the 1.3200-1.3250 area at present. In contrast to yesterday USD buyers have appeared this morning capping the immediate upside potential for EUR/USD and allowing the USD index to pull a little above yesterday's lows. One of the factors behind the USD's fall yesterday was a rise in speculation that the Fed could return to quantitative easing as soon as Aug 10 (QE2). There is still good reason to suspect that this conclusion is premature; while the pace of the US recovery has moderated the economy is still expanding. If the Fed announces steady policy next week, it could create a round of profit-taking on short USD positions.

This risk is likely providing the USD a little support this morning. That said Friday's payrolls is a more immediate focus. Bad data here will underpin the risk that the Fed will start easing again. Insofar as this week's data has provided sufficient disappointment to suggest that payrolls could be fairly grim it is unlikely that USD buying will garner much momentum in the coming sessions. Given the likelihood that ECB President Trichet will tomorrow confirm that the ECB will continue to 'normalise' policy there is still sufficient divergence between the policies of the Fed and ECB to conclude that EUR/USD may see additional upside ahead of the FOMC meeting next week. The US ADP employment data may offer some direction this afternoon.

Sterling took a tumble on the back of a weaker than expected July services PMI (53.1 from 54.4 in June). Despite the strength of recent retail sales and Q2 GDP data, this survey is one of the first to provide an insight into the key services sector in Q3. The market is expecting strong headwinds in H2 for the UK as the government embarks on its schedule of fiscal reform. This data suggests that the impact may be a little heavier than expected. Although still in expansionary territory, the service PMI is clearly struggling to reclaim its Feb peak of 58.4. In view of its recent gains sterling is presently more susceptible to disappointing economic news.

That said EUR/GBP retains a downside bias on the daily charts with the immediate outlook appearing consolidative. Cable found buyers near 1.5900 this morning, though 1.600 is likely to be a tough barrier.

Eurozone final services PMIs for July were generally a little lower than their flash estimates. The pace of expansion in both France and Germany is greater than that registered in the UK, though Italian services PMI has fallen back into 'contraction' territory. Although the clear recovery in the German economy will likely allow the ECB to continue to withdraw exceptional policy measures, other parts of the Eurozone (in particular Spain, Greece, Ireland and Portugal) will struggle to record any growth this year. Too much tightening of ECB liquidity provisions could bring the debt crisis back to the boil. When the EUR was initially launched it was envisaged that individual governments would use fiscal policy to fine tune uneven economic conditions which would inevitably result from a 'one size fits all' monetary policy.

Governments in Ireland, Greece and Spain failed to do this in the 'fat' years and their failures led to asset price bubbles in Ireland and Spain and to a badly managed budget in Greece. Now in the midst of their fiscal retrenchment they haven't got the spending power to offset any tightening in monetary conditions. The sovereign debt crisis in Europe has not evaporated and the ECB will have to trend carefully to keep the lid from blowing off.

Jawboning from the Japanese government continued overnight although the markets are hardly listening. It remains very unlikely that the MoF will decide to intervene in the market. USD/JPY remains key to the Japanese economy but to a lesser extend in recent years now that Asian export markets are being developed. Most central banks are loathe to take direct action in currency markets particularly when fundamentals suggest that they may fail to change the direction of an exchange rate. The present move in USD/JPY appears to be more a function of Fed policy than Japanese suggesting intervention could be futile. USD/JPY is hovering above 85.40.

US ADP and ISN non-manufacturing will be watched today.

Jane Foley

Research Director
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