Euro Finds Limited Support From Risk Appetite, As Correlation Weakens

EUR/USD

A rise in manufacturing in Europe, China and the U.S. helped spur risk appetite lending support for the EUR/USD but not to the degree of other risk sensitive pairs. Volatility in equity markets are now only explaining 35% of price action compared with 59% a month ago as the pair has started to see its relationship with risk dissipate. Credit troubles in Greece sunk the euro/dollar at a faster pace than tumbling stocks as fears grew the region’s downside risks were greater than the global economy. The deterioration of the relationship requires traders to reevaluate the pair’s potential reaction to U.S. fundamental releases where there has been a positive correlation. Additionally, a rise in U.S. interest rate expectations could start to have a negative impact on future price direction as we move through the year and get closer to the beginning of tightening from the FOMC.

ECB Interest Rate Expectations

Overnight Index Swaps are pricing in 81 bps of tightening over the next twelve months which is significantly lower than the 109.9 at the beginning of the year. Troubles in Greece, Portugal, Ireland and Spain have offset the growth that the regions’ largest economies Germany and France have generated. Therefore, the ECB is expected to remain on hold until late 2010 and with inflation remaining well below their 2% target they could refrain from tightening until 2011. This week’s policy meeting could have a significant impact on yield expectations, if we see a change in language from President Trichet in the post release press conference from the ongoing “risks remain balanced”. To discuss this and trading ideas join the EUR/USD forum.

FOMC Interest Rate Expectations

Fed funds futures are now pricing in a 38.8% chance of a rate hike by June following the better than expected manufacturing data. The upcoming Non-farm payroll report has the greatest potential to alter yield expectations as the U.S. economy is expected to have added 10,000 jobs in January. Job growth will increase the chances that the FOMC would consider tightening and could see the horizon for a rate hike shorten.

Risk

Equity markets were higher on the day on the back of the continued strength in manufacturing. We have started to see the Dow consolidate following a test of trend line support and just above 10,000. The significant psychological; level should prove to be formidable support and may increase the upside potential. Strong service sector and labor reports should add to the bullish sentiment generated by the increase in manufacturing activity. 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