Euro/Dollar Remains Driven by Risk, After Fed Tempers Interest Rate Expectations

The EURUSD continues to see its correlation to risk hold firm as equity markets are currently explaining 47% of price action. The pair continues to see little relationship with interest rate expectations with overnight index swaps holding only a 0.1 correlation with price direction.

[B]EUR/USD[/B]

The EURUSD continues to see its correlation to risk hold firm as equity markets are currently explaining 47% of price action. The pair continues to see little relationship with interest rate expectations with overnight index swaps holding only a 0.1 correlation with price direction. The ECB and FED have continued to try and temper interest rate expectations with warnings of downside risks and pledges to continue stimulus efforts. However, as signs of stabilization mount and prices start to rise, policy decisions will become more difficult and yield expectations would grow in importance regarding price action for the pair. Conversely, if growth signs falter then waning risk appetite could weigh on the pair as it would remain its primary driver of price action.

[B]ECB Interest Rate Expectations[/B]

Despite the ECB’s efforts, interest rate expectations are on the rise with markets pricing in nearly 90 bps of rate hikes over the next twelve months. Today governing council member Erkki Likanen was quoted in the Financial Times as saying ‘there are two issues – how and when. We are not in a hurry now. If you look at the growth in Europe, it is about to recover – but clearly from a lower level. Growth will be below potential,’ A rise in German business confidence to a 12 month high and the Euro-zone PMI reading showing expansion in the service and manufacturing sectors for a consecutive month add to the case for a recovery. Therefore, policy maker’s rhetoric may not be able to subdue expectations for long if growth signs continue to emerge.

[B]FOMC Interest Rate Expectations[/B]

Fed funds futures are currently pricing in a 2.3% chance of a rate hike by the end of the year after the FOMC left rates unchanged yesterday and reaffirmed its commitment to keep them low for an “extended period”. The central bank also pledged to fulfill its current asset purchase program of $1.25 trillion but extended its end date to March from December. Spreading out the stimulus efforts is an attempt to keep support under the housing sector but will also extend the horizon of when markets may expect tightening to begin. This could maintain the greenback’s status as a funding currency and as long as risk appetite remains strong it will see continues weakness.

[B]Risk Appetite [/B]

Equity markets are starting to come up against technical resistance levels with the Dow being slowed by the 61.8% Fibo retracement level of the decline from the middle of 2008. The psychological level of 10,000 also looms above as a potential barrier which could lead to a retracement for stocks. If this is the case then absent a rise in ECB interest rate expectations the EUR/USD could also see similar weakness. Conversely, the improving fundamental data could lead investors to ignore potential pitfalls for growth and look to push valuations to pre-crisis levels and extending the current bullish Euro momentum.

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