Euro May Continue To Climb As Equity Markets Look To Test Pre-crisis Levels

The EURUSD continues to set fresh yearly highs as the pair continues to be driven by risk sentiment which currently accounts for 46% of price action. Its influence has soared since the Lehman collapse but we have seen it start to level which could lead to interest rate

EUR/USD

The EURUSD continues to set fresh yearly highs as the pair continues to be driven by risk sentiment which currently accounts for 46% of price action. Its influence has soared since the Lehman collapse but we have seen it start to level which could lead to interest rate expectations having a greater impact on direction. However, we still see that both European and U.S. yield expectations are having very little sway over sentiment as it is widely expected that both central banks will keep rates on hold for the remainder of the year. Therefore, with equity markets still far from pre-Lehman levels there could remain considerable upside for the Euro.

ECB Interest Rate Expectations

ECB interest rate expectations have sharply rebounded in the past few days which helped add to the prevailing Euro bullish sentiment. Overnight Index Swaps are currently pricing in 88.3 bps of rate hikes over the next twelve months which is up from 31.7 on 9/7. Dovish talk from ECB president Trichet had lowered expectations that policy makers will begin tightening in the near-term. The central bank head stated that there is “a bumpy road ahead" and that the current situation still requires "caution, prudence and alertness." Furthermore, when speaking about the central bank’s exit strategy from current efforts to provide liquidity he emphasized that “It does not include considerations about interest policy.” The uncertainty of future monetary policy has limited its impact on price action, but with the obvious next step for the ECB to tighten we may start to see it have a greater influence as the picture for future growth clears.

FOMC Interest Rate Expectations

Like the ECB the FOMC has looked to temper the outlook for future rate hikes which has led to a decline in the probability of tightening beginning before the end of the year. Fed funds futures went from pricing in a 12.7% chance of a 50 bps hike in December to 7.0% over the past month. Signs that the U.S. economy was stabilizing had fueled expectations that policy makers fearful of creating another bubble would start to tighten as soon as possible. Indeed, the recent consumer price report which showed inflation rose 0.4% in August led to a 5.5% increase in the past week for a policy change. However, with unemployment on track to reach 10.0% we may see expectations remain subdued until the economy starts to create jobs which could limit upside potential for the dollar.

Risk Sentiment

Risk trends have been the main driver of price action for the EUR/USD and the DJIA current bullish trend has helped push the pair to a new yearly high. Traders have started to look past the lingering downside potential for growth as the recent G-20 summit demonstrated that global leaders are committed to maintaining current accommodating efforts until there are clears signs that a recovery has taken hold. However, these same leaders continue to warn of potential downside risks which may curb risk appetite but with the DJIA remains over a 1,000 points from pre-Lehman levels we could still see the rally extend to test those marks.

To discuss this report contact John Rivera, Currency Analyst: jrivera@fxcm.com