EUR/USD’s Correlation with Risk Threatened by Upcoming Inflation Data

EUR/USD

The Euro has started to consolidate after seeing volatility overnight on the back of the Dubai debt bailout and dour fundamental data. Equity markets which have been the main driver of the EUR/USD have seen mild support as markets have already moved past the issue. However, we still see risk sentiment hold considerable sway over price direction with a 59% correlation. Improving U.S. employment and consumption data has raised interest rate expectations in the world’s largest economy which should start to threaten the dollar’s status as a funding currency. Therefore, we could see the greenback’s negative relationship with risk dissipate which will increase the influence of yielded expectations on the pair’s direction. Indeed, we are seeing the outlook for U.S. interest rates have an increasing influence on the pair with a negative 15% correlation.

ECB Interest Rate Expectations

Euro interest rate expectations have fallen again as policy makers continue to emphasis that the ending of liquidity measures doesn’t signal that the ECB will begin to tighten monetary policy. Governing Council member Erkki Liikanen stated that financial markets have understood the European Central Bank's exit from extraordinary liquidity measures is not a signal on interest rates. Overnight index swaps are only pricing in 90 bps worth of rate hikes over the next twelve months which is down from its recent high of 103 bps on December 4th.  Dour fundamental data released today only reinforced the central bank’s concerns that the recovery will be moderate with downside risks remaining. . The Euro-zone employment report showed a fifth straight quarterly decline in the three months ending September, while industrial production declined for the first time in five months. Inflation in the region is forecasted to remain unchanged at 1.2% which will give policy makers time to better assess the potential for growth. To discuss this and trading ideas join the EUR/USD forum.

FOMC Interest Rate Expectations

U.S. interest expectations have started to perk up again following the 1.3% rise in November’s advance retail sales. The increase in demand more than doubled the 0.6% that was expected raising hopes for a solid holiday shopping season. The improved consumption data came on the back of a stronger than expected labor report which showed the economy lost 11,000 jobs which was the first time in nearly two years the economy didn’t see triple digit losses. Despite, the improving fundamentals the Fed has maintained that they will leave rate on hold until mid 2010. However, the upcoming inflation report could alter policy makers rhetoric with consumer prices expected to have surged 1.8% from a year ago.

Risk

Equity markets continue to remain range bound despite recent support. The Dow is currently looking to test the upper bound where we have seen 10,500 serve as staunch resistance. A break above the level could lead to a breakout which could generate EUR/USD support. However, a lack of a catalyst may see the blue chip index continue to trade sideways setting up the Euro for a quiet ending to the year. U.S. inflation is expected to have sky rocketed to 1.8% from -0.2% which could lower expectations for future demand, increasing downside risks. 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