Is the Euro’s Correlation with Risk Deteriorating?

EUR/USD

The EUR/USD continues to trend lower as broader dollar strength and concerns over the European financial system have taken turns generating bearish sentiment. The prospect of higher U.S. interest rates has started to impact price action with a -0.18 correlation which raises the question of how much longer will risk sentiment drive price action. We currently see that movements in the Dow are still explaining 60% of volatility which has been the case for the past month. However, with equities trading higher today and the pair heading for a fifth consecutive down day, is this relationship deteriorating?

ECB Interest Rate Expectations

ECB interest rate expectations are in a clear down trend as the central bank has taken every opportunity to reaffirm its commitment to a low interest rate environment. The troubles in Greeece and Asutria have only reinforced this notion which has seen markets lower their forecast from 103 bps to 89 bps of tightening over the past few weeks. ECB member Athanasios Orphanides showed concern that underlying risks to inflation are significant which will keep the central bank on hold. He stated in an interview in the Financial Times that “We need to ensure that policy remains sufficiently accommodative in order to avoid the risk of a very extended period of undershooting.” Therefore, Euro bulls shouldn’t expect any help from policy makers, increasing downside risks or the single currency. To discuss this and trading ideas join the EUR/USD forum.

FOMC Interest Rate Expectations

U.S. interest expectations pushed higher and may continue to do so if we see signs that the U.S. economy is steadily improving. Personal income and spending figure this week will provide evidence as to whether the consumer has the ability and the appetite to take the baton of consumption from the government. Markets are starting to signal that they believe that this is the case with the spread between the 2 and 10-year treasury notes have widened to the most ever. The improving outlook for U.S. yields should continue to weigh on the EUR/USD, if the ECB is expected to remain on hold.

Risk

Equity markets have rebounded today after testing the lower bound of their current range. The upcoming Holiday’s is expected to bring thin volume which could perpetuate the sideways price action. However, traders may look for signs of the beginning of a new trend and could look to get in early before the New Year brings confirmation. If we continue to see evidence of the relationship between the Euro and risk appetite breaking down then traders should adjust their strategies accordingly. 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