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Euro Rallies on ECB Rate Forecasts, but is Reversal More Likely?

Euro Rallies on ECB Rate Forecasts, but is Reversal More Likely?

2011-03-05 00:39:00
David Rodriguez, Head of Business Development
Euro_Rallies_on_ECB_Rate_Forecasts_but_is_Reversal_More_Likely_body_Picture_1.png, Euro Rallies on ECB Rate Forecasts, but is Reversal More Likely?

Euro Rallies on ECB Rate Forecasts, but is Reversal More Likely?

Fundamental Forecast for Euro: Neutral

- Euro strengthens sharply on European Central Bank interest rate announcement

- A Euro/US Dollar drop below 1.3740 would point to an important reversal

- Busy week of US economic event risk could affect Euro/US Dollar direction

The Euro finished the week sharply higher against major counterparts, boosted by a dramatic improvement in European yield forecasts and broader US Dollar weakness. European Central Bank President Jean Claude Trichet surprised markets in strongly hinting that the bank would raise interest rates at their upcoming meeting. Overnight Index Swaps now price in a 100 percent probability of a 25bp interest rate hike as Trichet said the ECB remained “strongly vigilant” on price pressures—a phrase that served to warn markets of an imminent rate increase through the bank’s last tightening cycle. Strong upward momentum leaves the Euro/US Dollar positioned for further gains, but failure to hold the 1.40 mark warns the pair may face an uphill battle in a busy week for global economic event risk.

Markets now predict that the ECB will raise rates by a cumulative 125 basis points in the coming months—the highest such predictions in at least five years. Such lofty expectations leave focus squarely on upcoming European economic data, and a modestly busy week of German economic event risk could spark short-term volatility in Euro pairs. Highlights will include Factory Orders, Industrial Production, Current Account, Wholesale Price Index inflation, and Consumer Price Index inflation reports. None of these data releases have historically produced major EUR volatility, but we can’t rule out reactions on any especially large surprises.

The sudden shift in European Central Bank rhetoric adds a new dynamic to Euro trading, and it will remain important to monitor official rhetoric going forward. The ECB becomes one of the very few central banks expected to raise rates consistently through the coming 12 months—a factor that should support it against lower-yielding counterparts. Yet it is admittedly difficult to reconcile the effects of yield forecasts with the real risk of further Euro Zone fiscal crises. Jean Claude Trichet made it clear that the central bank was responsible for inflation for the broader EMU and had to act in the face of rising price pressures. Of course, higher interest rates will hardly help the beleaguered Spanish real estate market or central governments facing exceedingly high borrowing costs. It is far from clear how to balance the two distinctly different risks to the euro currency, and we need to remain vigilant in the face of uncertain fundamental trends.

Recent CFTC Commitment of Traders data shows Non-Commercial traders are the most net-long EURUSD since January, 2008. As we have written on a number of occasions now, it is very difficult to identify sentiment extremes until well after the fact. Yet such one-sided positions warn that the ‘boat’ has become extremely crowded, and a sudden shift towards EUR selling could force especially sharp corrections. COT data shows that large speculators remain heavily net-short the US Dollar across the board.

A solid US Nonfarm Payrolls report was not enough to spark a Greenback bounce. Yet the report likewise emphasized that all is not doom and gloom for the US economy. Fundamental data and sentiment is frequently at its most bullish at or near a market top. Can recent ECB developments be the sign that the EURUSD is headed for a sharp correction? We will watch for any such developments and closely monitor the trajectory of Euro pairs through the coming week of trade. -DR

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