Global Session: Sentiment wanes as Diamond loses his shine

It's not unusual to see extreme moves in holiday-thinned markets and the acceleration in the decline in EURUSD this afternoon may have been caused by mild risk aversion and light volume. EURUSD never looked happy above 1.26 today and after dropping through 1.2575 - a key support zone - it continued to decline until finding support just above 1.25 as we wait for the ECB tomorrow. The Bank is expected to cut rates by 25 basis points, which could erode the euro's yield differential with some of the major crosses such as the dollar and the Aussie.

Is there a chance of a 75bo cut from the ECB?

The majority of economists surveyed by Bloomberg now expect the Bank to cut rates, thus if it fails to do so (which is a low probability event in our view) it could generate disappointment in the markets and we could see risky assets, including the euro, start to sell off. We think a rate cut may be more of a symbolic gesture to show the markets that the Bank will step up its action if governments' do so first. While a rate cut is only likely to have limited impact on growth, we think re-starting the Bank's SMP programme, which could then buy the debt of Spain and Italy, would be more effective at stabilising the situation in the currency bloc. However, the Bundesbank, a powerful force in the ECB, is likely to prefer a rate cut since inflation in Germany has started to moderate, while it has been steadfastly against the SMP programme since its introduction. Thus we don't expect any unconventional measures from the ECB tomorrow.

The markets may be selling the rumour (of a potential larger rate cut than 25bps) only to buy the fact (if the ECB only cuts by 25bps) tomorrow when the decision comes out. We don't think a rate cut by the ECB is enough to drive the euro out of its most recent range between 1.24-1.27. Instead, we need to hear from Europe's politicians and their commitment to the steps addressed at the EU summit before we know if there is a meaningful decline in credit risk in the periphery. Only when we see a sustainable decline in credit risk do we believe that EURUSD could break out to the topside, thus tomorrow's ECB decision may end up being a bit of a damp squib for the markets.

Fundamentals back in vogue

Today we saw EURSEK fall to its lowest level since 2000 after the Riksbank left rates on hold. This has raised the hope that fundamentals could come back to drive FX markets. After all, the rate differential is favourable to SEK strength, and the Nordic economy doesn't have the same problems as the Eurozone, hence it could extend declines from here. Below 8.65 opens the way for a test of 8.60 then towards 8.54.

Economic data also weighed on risk sentiment today. The service sector PMI's in the Eurozone were better than expected but still remain deep in contraction territory. The PMI composite rose to 46.4, up from 46.0 in May. This is the 5th straight month in contraction territory and suggests the Eurozone economy may have contracted in Q2. Not even Germany, whose service sector has held up quite well in recent months, could avoid the decline and its reading fell to 49.9 from 50.3 in May. This is the lowest level since autumn 2011.

Diamond doesn't dish dirt on the BOE

The UK's service sector PMI remains in expansionary territory, but it suffered a hefty fall in June to 51.3 vs. 53.3 in May. This was overshadowed as the former Barclays boss Bob Diamond who appeared in front of the Commons Select Committee this afternoon. At the time of writing Diamond is still speaking, but we have been able to glean some information from his testimony. Firstly, Diamond really LOVES Barclay's; secondly he was not CEO when the Libor fixing scandal first began. Thirdly, Libor fixing first took place before 2008. Diamond said he did not think that the BOE gave the signal to lower the Libor rate in 2008, during the peak of market stress; but the links between banks/ the BOE and the government during this time remains murky and this hearing did not clear this matter up.

The Committee has been at pains to highlight the difference between the Libor fixing prior to 2008, which may be criminal if traders did it to enlarge their own pay packets, and lowering its Libor rates in 2008 at the peak of the financial crisis. Diamond seemed to suggest that people in Whitehall were worried that Barclay's may also need a state bailout if its borrowing costs kept rising; hence the Bank (without Diamond's knowledge) lowered its borrowing costs to make itself look safer. Diamond's PR team must have patted themselves on the back for that one, as Diamond seemed to suggest that Barclay's actually saved the taxpayer money!

Overall, the performance (so far) has been fine from Diamond. He was fairly chummy with some on the Committee, which is unlikely to go down well with some sections of the press, especially since one member of the Committee had worked at Barclays in the past. But overall, for those of us watching it the committee was left wanting and some members wasted the opportunity to ask real probing questions. At one point Diamond was asked if he lived in a parallel universe. So this crisis is far from over.

Market moves

The pound has been another casualty of the dollar resurgence, and is below 1.56 at the time of writing. This is unlikely to be due to Libor-gate, and more down to expectations of QE from the Bank of England tomorrow. Like the ECB, we could be in sell the rumour, buy the fact mode, if the BOE chooses to do GBP50 billion of purchases at tomorrow's meeting. Below 1.5595 - Tenkan line on the cloud - opens the way for a more prolonged decline to 1.5500. If market sentiment improves post the BOE then we may see a recovery to 1.57 - the near-term top.

The resurgence in the dollar has weighed on stocks and commodities, which have declined modestly into the European close. Tomorrow ADP data and the ISM non-manufacturing data will be the key events from the US to watch out for along with the ECB and BOE meetings.

Best Regards,

Kathleen Brooks| Research Director UK EMEA | FOREX.com

d: +44.(0).20.7429.7924 | f: +44.(0).20.7929.2010 | M: +44 (0) 7919.411.957 | e: kbrooks@forex.com| w: www.forex.com/uk

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