Euro drifts ahead of ECB, no-deal nerves knock sterling

The euro-dollar exchange rate drifted lower as traders bid their time on Tuesday ahead of the European Central Bank’s post-summer meeting later in the week, while renewed warnings from London of a no-deal Brexit kept sterling on the slide.

The euro bobbed around $1.18 but the pound was at two-week low of $1.3125 and the yuan back-pedalled too after US President Donald Trump warned about "decoupling" the US and Chinese economies.

Britain went into Tuesday's fresh round of Brexit trade talks with a warning to the European Union that it was ramping up preparations to leave without an agreement at the end of the year.

"Clearly the headlines about the UK government drawing up some withdrawal agreement overrides is not going to sit well with officials in Brussels if they are true," said Lombard Odier's head of FX strategy Vasileios Gkionakis.

"We are still looking for a skinny, skeleton, basic deal whatever you want to call it. But as time draws on, the risk of a no deal Brexit rises."

Moves in the Asian day had been modest, with the dollar back under gentle pressure as risk appetite appeared to return to equity markets.

The Australian dollar was up at $0.7276 and the New Zealand dollar was little changed at $0.6685, having hit lows overnight following a Sunday statement from the central bank which again raised the prospect of negative rates.

The main focus this week is on the European Central Bank's policy decision on Thursday.

Most analysts don't expect a change in the central bank's policy stance but are looking to the message on its inflation forecasts and whether it seems concerned by the euro's strength. 

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The meeting comes after the single currency marked a two-year high just above $1.20 at the beginning of the month, until comments on how the exchange rate "does matter" from ECB chief economist Philip Lane knocked it lower.

Lombard Odier's Gkionakis said some more verbal intervention from ECB head Christine Lagarde was probably more likely than formal concerns at this point, a view shared by other analysts.

"The ECB could raise more concerns over a further appreciation in the euro and make some downward revisions to its inflation projections," said Commonwealth Bank of Australia currency analyst Kim Mundy, which would flag easier policy.

Both said the euro would take a hit if the ECB did take a stronger stance.

Elsewhere, the dollar traded firmly against the Japanese yen amid talk of a snap election - something that Yoshihide Suga, frontrunner to succeed Shinzo Abe in next week's leadership ballot - signalled in a newspaper interview.

Analysts say many currency market participants no longer consider the leadership race as a catalyst, as the next leader is likely to follow Abe's policy path.

"Around eight years ago (when Abe took over), the yen was stronger at around 70 per dollar. But with the current dollar/yen level, there's nothing much the successor can do currency-wise," said Daisuke Karakama, chief market strategist at Mizuho Bank.

"The stronger local equity market should be more of a concern instead," he said.

The yen last changed hands at 106.29 per dollar.

Some traders also sold sterling against the yen, last traded at 139.63, hovering near a two-week low of 139.58 it hit in the previous session.

Japan's economy shrank an annualised 28.1% in April-June, worse than the initial estimate of a 27.8% contraction, revised data from the Cabinet Office showed on Tuesday.

Final European GDP figures are also due later in the day.

Reuters