Euro Supported As Equity Markets Soar, Is It Sustainable?

EUR/USD

The EUR/USD sharply fell today on the back of dollar supportive comments from Fed Chairman Ben Bernanke before regaining its footing. It was a rare instance where volatility wasn’t generated by risk appetite, as movements in equity markets are currently explaining 61% of price action for the pair. A pledge by central banks in the U.S. and Europe to maintain stimulus efforts and maintain a low interest rate environment has minimized the importance of interest rate expectations. Policy makers will most likely keep rhetoric to a minimum heading onto the holiday season as the prime period for consumer consumption will impact the outlook for future growth and could alter current forecasts. Therefore, traders looking to trade the Euro should continue to monitor stock markets which continue to trade higher for direction. However, resistance at 1.500 holding today could be a sign that we may start to see a divergence between risk and the single currency or weakness ahead for both.

ECB Interest Rate Expectations

Interest rate expectations for the ECB have fallen sharply over the past few weeks as the central bank remains committed to their current accommodative monetary policy without the threat of inflation. Governing Council member Athanasios Orphanides stated in a recent interview that the ECB's current "very accommodative" stance with record low interest rates was appropriate at this time.  Today’s release of the October Euro-zone consumer price report would eliminate any concerns as it showed negative inflation for a fifth straight month. Although the pace of the decline slowed from -0.3% to -0.1%, a drop in the core reading to 1.1% from 1.2% speaks more of deflation than potential upside risks. Overnight index swaps are now pricing in 78.6 bps of rate hikes over the next twelve months down from 99.7 on November 6th which may bullish potential for the Euro, despite the current relationship between the two.

FOMC Interest Rate Expectations

Fed Chairman Ben Bernanke speaking in front of the Economic Club of New York stated that the central bank continues to see an economy "likely to warrant exceptionally low levels of the federal funds rate for an extended period." Low inflation, rising unemployment and weak consumer spending are expected to continue to make the case for an accommodative monetary policy. Fed Funds futures are now pricing in a16.3 chance of a ret hike at the March meeting which is most likely the soonest that we could expect tightening to begin.

Risk

Equity markets continue to reach higher after breaking above resistance at 10,334 -50.0% Fibo of the 14,198-6469 decline on the back of stronger than expected retail sales and continued expansion in manufacturing. A rebound in automobile purchases absent government stimulus is an encouraging sign for future domestic growth. The prospect of prolonged government stimulus continues to bolster risk appetite leaving the possibility of a test of resistance at 1156.60-76.4% Fibo of 13,136-6469, where we also see former congestion. However, equity markets remain vulnerable to a sharp pullback if traders come to the realization that future profits may not stand up to current valuations. Until then, more bullish Euro sentiment may be expected, especially if we see psychological resistance at 1.500 finally conquered.

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