Euro and Dow Challenge Psychological Barriers, Will The Rally End?

EUR/USD

The EUR/USD has been held in check by the psychological resistance level of 1.500, which the pair recently broke above for the first time in over a year. We have seen a similar scenario with the Dow and 10,000 which could be expected as the blue chip index is currently explaining 61% of price action for the pair. Meanwhile, ECB interest rate expectations have started to grow in importance in determining price direction as we approach 2010.  The central bank will most likely remain on hold until then, making each successive policy decision more important and influential.

ECB Interest Rate Expectations

ECB interest rate expectations are slightly lower from their recent high of 101.5 on 10/09 as dovish rhetoric from committee  members continues to push out the timeline for rate hikes. Indeed, Axel Weber, who represents Germany's Bundesbank stated that "the monetary policy stance is determined by risks to price stability, which are fortunately currently not present on the policy-relevant time horizon.” Euro-zone inflation has fallen for four straight months as energy costs plunged from record highs in July 2008. It hit an all-time low at minus 0.7 percent in July and currently stands at minus 0.3 percent. However, as long as growth continues for the economic region upside risks may be around the corner and given the central bank’s price stability mandate, a rate hike could be imminent. Tomorrow’s German IFO survey is expected to show that investor confidence rose to its highest level in over a year which should add to the bullish sentiment over the economy and may push yield forecasts higher.

FOMC Interest Rate Expectations

Fed funds futures are currently pricing in an 8.6% chance of a rate hike by the end of the year which is the highest in over a month. Additionally, markets also raised the likelihood of a 75 bps rise in the target rate in January to 2.3% but simultaneously lowered the overall chances of tightening from 30.4% to 23.5%. The FOMC may remain on hold longer than previously expected which could increase the chances of an aggressive move once they decide to tighten. The Fed beige book report showed that there was modest improvement in most districts and that signs of stabilization are increasing. However, there was still eroding credit markets, weak consumer demand and subdued price pressures across most districts which most likely keep the FOMC on hold through early 2010.

Risk

The Dow’s break of 10,000 saw the prior rally give way to a period of choppy price action, with traders look for the next catalyst. Strong corporate earnings remain a supporting factor for the blue chip index with components 3M, AT&T and McDonald’s all beating estimates today. However, an uptick in initial jobless claims to 531K from 520K was a quick reminder that rising unemployment will remain a weighing factor on consumer consumption. Companies will be hard pressed to beat estimates in the fourth quarter without an increase in spending as the impact from the inventory cycle and government stimulus will start to dissipate. Therefore, a retracement in equities is likely which could drag the EUR/USD lower.

To discuss this report or be added to the email list contact John Rivera, Currency Analyst: jrivera@fxcm.com