Euro Shows Signs Of Diverging From Equity Markets

EUR/USD

Budget deficit issues continue to plague the single currency and were a main catalyst for overnight weakness. The Euro has begun to erase earlier losses as positive equity markets have lent support. Stock fluctuations continue to hold sway over the EUR/USD explaining 48% of its volatility. However, when we look at a comparison of price charts we are starting to see the two begin to diverge again which could be a sign that the relationship is faltering now that broad based risk aversion is fading. Meanwhile, interest rate expectations continue to take a back seat as both the ECB and Fed have signaled that they will remain on hold for an extended period. The U.S. central bank raising their discount rate was the first sign that policy makers are moving toward tightening. Therefore, we have seen the negative correlation between the U.S. yield outlook and the pair begin to increase in importance.

ECB Interest Rate Expectations

Overnight Index Swaps are pricing a 52.3 bps of tightening which is continuing to sink lower as the budget deficit issues are seen as a significant barrier to a change in monetary policy. The IMF in its staff report today stated that “sovereign vulnerabilities” in the E.U. remain a downside risk. The ECB is expected to remain on hold at this week’s rate decision and will most likely maintain their previous rhetoric which could lower the outlook for interest rates further, adding further weight to the Euro. To discuss this and trading ideas join the EUR/USD forum.

FOMC Interest Rate Expectations

Fed funds futures are now pricing in only a 2.5% chance of a rate hike by April with no chance at the FOMC’s upcoming meeting on March 16th, as chairman Ben Bernanke has taken every instance to talk down potential tightening following the raising of the discount rate. The upcoming Non-farm payroll report will have a considerable impact of the direction of future policy as the lack of job growth has been a barrier for any rate hike. Forecasts are for a decline of 50,000 which will dim any expectations of a change in policy during the first half of the year, which could weigh on the greenback.

Risk

Equity markets continue to find support despite the troubles in Greece and the prospect of continued job losses in the U.S. The expectation that the current low interest rate environment will be sustained has raised the outlook for corporate profits. Cheap credit, rising prices and a stabilizing labor market bode well for companies that are already operating at very lean levels. The recent break of trend line resistance may signal that more gains are ahead, as a forming triangle warns of a potential breakout and recent price action points toward the upside. Of course, a dour labor report could quickly erase optimism and lead stocks and the EUR/USD lower. 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