Euro Re-establishes Risk Correlation on Sovereign Credit Concerns

EUR/USD

The EUR/USD has quieted following a bout of volatility, as budget deficit issues in Greece, Portugal and Spain raised broader concerns and sparked a flight to safety. Risky assets traded lower following the Euro’s lead which was already under pressure from the bulging shortfalls of its member nations. The dollar benefitted from the on-going risk aversion, as it continues to hold onto its safe-haven status. This led to the EUR/USD re-establishing its correlation with risk, which is currently explaining 48% of price action versus 39% a week ago. The correlation is considerably weaker than last month’s 63%, but still accounts for a considerable amount of the pair’s price direction and must be considered when taking positions. Meanwhile, markets expectations that the Fed and ECB will keep rates on hold throughout the first part of the year which has made yield expectations inconsequential in explaining price action, leaving risk as the main driver.

ECB Interest Rate Expectations

European interest rate expectations fell sharply following the ECB’s rate decision last week with Overnight Index Swaps dropping to 68.1 from 86.6. Policy makers’ continue to view current rates “appropriate” as growth and inflation risks remain balanced. President Trichet stated n the post release press conference that inflation expectations remain anchored for the medium and long-term. However, the central bank leader made a point to stress that price stability is their first mandate and of utmost importance. Therefore, any threat of a rise in consumer prices could lead to a rise in the outlook for future tightening. To discuss this and trading ideas join the EUR/USD forum.

FOMC Interest Rate Expectations

The upcoming U.S. advance retails sales report is the most significant release in a light week for event risk. Economists are forecasting a 0.3% rise in demand for January which could raise interest rate expectations as strong consumer consumption will put upward pressure on prices. Rising inflation would be the one catalyst that could shorten the horizon for future tightening. Fed Funds futures continue to reflect the dimming outlook for a rate hike with a zero percent chance at the March meeting (therefore not worth showing), and only a 28.7% chance by August.

Risk

After breaking below 10,000 on early Friday the Dow regained its footing and has entered a period of consolidation. The resulting price action has developed a triangle formation which is typically a warning for a breakout. The downside is favored considering the prevailing risk aversion over the European sovereign debt concerns. However, considering the sharp move lower the Blue chip index could see a reversal. Also making the case for a bullish move is Friday’s hammer candle. 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