Euro’s Correlation with Risk Wavers, as Dollar Funding Status in Doubt

EUR/USD

The Euro briefly regained its footing on the back of dovish comments from Fed Chairman Ben Bernanke which led to the dollar giving back some of its recent gains. The central bank’s leader’s remark that the U.S. economy still faces “significant headwinds” offset the better than expected Non-Farm payroll print. The greenback has been widely used as a funding source and the strong labor report on Friday raised the outlook for U.S. interest rates leading to a reversal of flows back into the reserve currency. The bearish EUR/USD price action was a divergence from its ongoing lockstep movements with equities, which saw support from the surprising data. Despite the drop in the pair’s correlation with risk appetite it still accounts for 58% of price action and must be taken into account. Yet, traders must start to monitor this relationship as a shift could lead to Euro interest rate expectations taken on a greater role in price direction, despite its current correlation of negative 0.13.

ECB Interest Rate Expectations

ECB interest rate expectations have surged higher after the central bank took steps to bring an end to their liquidity providing measures. However, the central bank’s announcement fell short of market expectations which were looking for a timetable for removing liquidity from the market. President Trichet called the current rate appropriate as risks remained balanced with inflation expected to moderate over the medium to long term. Policy maker’s moves going forward should start to grow in significance as the dollar ends its role as a funding currency and the pair starts to lose its correlation with risk. An unexpected drop in German factory orders in October underlines the fact that there exist downside risks to growth and should limit expectations for a rate hike over the near-term. Therefore, we could see the EUR/USD remain in its current range of 1.4700-1.5100.  To discuss this and trading ideas join the EUR/USD forum.

FOMC Interest Rate Expectations

U.S. interest expectations have resumed their downward trend as the impact from the labor report is starting to dissipate. The dovish comments from Chairman Ben Bernanke should only lower yield expectations. Bernanke warned that household spending is “unlikely to grow rapidly” as credit remains tight and the job market weak. Despite November’s improvement, unemployment remains at a debilitating 10.0% which the Fed chairman says will lead to a moderate recovery pace. Bernanke would go onto say that the Fed is still looking at an extended period before beginning tightening as long-run inflation expectations are stable.

Risk

Equity markets are struggling to hold onto earlier gains on the day on the prospect of a low interest rate environment continuing for an extended period. However, we still see the Dow struggling to break above 10,500 despite evidence that the labor market is improving faster than expected. Therefore, the potential for a correction exists and considering recent consolidation, a breakout could be imminent. Expect risk trends to continue to influence EUR/USD price action with a break below 10,000 in the Dow significantly increase the downside risk for both. To discuss this and other fundamental data join the Economics Forum.

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