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Euro Surges as ECB Comments Force Panic – Can it Continue Higher?

Euro Surges as ECB Comments Force Panic – Can it Continue Higher?

2012-07-27 22:49:00
David Rodriguez, Head of Product
Euro_Surges_as_ECB_Comments_Force_Panic__Can_it_Continue_Higher_body_Picture_5.png, Euro Surges as ECB Comments Force Panic – Can it Continue Higher?

Fundamental Forecast for the Euro: Neutral

Talk of fresh European Central Bank bond buying sparked a remarkable Euro surge against the US Dollar (ticker: USDOLLAR), and the weight of expectations on the Euro currency is substantial ahead of the coming week’s critical ECB and US Federal Reserve policy meetings.

The Euro posted its largest single-week gain against the US Dollar in five months on what seemed to be an aggressive bout of short covering across Euro currency pairs. Yet a pivotal week of event risk could just as easily reverse EURUSD fortunes as tensions are riding high ahead of a potentially pivotal European Central Bank rate decision.

European fiscal crises took a remarkable turn for the worse as Spanish government bond yields surged to fresh Euro era highs, while Italian bonds were not far behind. Spain’s 10-year government bond yield hit peaks of 7.75 percent—well-above the psychologically significant 7 percent mark at which point Greece, Ireland, and Portugal were forced to seek bailouts. More worrying than longer-dated bonds, however: 2-year yields rocketed to 7.15 percent.

The short-dated end of the bond yield curve is especially a concern since it is unlikely Spain or any other at-risk country would week to auction 10-year debt in the current environment. But a surge in 2-year rates could effectively limit Spain to borrowing at 1, 3, and 6-month intervals—in effect putting government solvency to the test on a near-monthly basis. Why then, did the Euro surge?

ECB President Mario Draghi took markets by surprise when he said that unreasonably high government borrowing costs could fall under the independent central bank’s monetary policy mandate. In other words, Draghi and the ECB Governing Council could take further controversial steps specifically aimed at purchasing European government bonds. Such speculation was magnified when he said the ECB would “do whatever it takes to preserve the euro” and emphasized “believe me, it will be enough.”

European government bond markets and the euro instantly rallied at an almost-incredible pace. Draghi’s comments were just the catalyst needed to spark a significant Euro short-covering rally that lasted into Friday’s close. Yet all eyes will train on the ECB rate decision on Thursday and Draghi’s every word in the post-announcement press conference. The central bank looks unlikely to cut its main interest rate of 0.75 percent, as real interbank lending rates are already effectively at zero percent according to the British Bankers Association. Beyond rates, expectations are running high that Draghi will introduce new government bond buying measures. A disappointment could prove disastrous given the sharp EUR rally seen on earlier speculation.

The pronounced uncertainty ahead of potentially pivotal event risk could encourage speculators to shed short positions ahead of Thursday, while a similarly anticipated US Federal Open Market Committee (FOMC) decision on Wednesday could likewise drive volatility.

The Dow Jones FXCM Dollar Index fell to fresh multi-month lows as the Euro and other currencies surged. Some claim the USD sold off on speculation that the FOMC will announce its third wave of Quantitative Easing (QE3), and indeed Overnight Index Swaps show that interest rate traders expect the Fed to ease further in the next 12 months. Yet it seems simplistic to claim that the US currency could fall specifically ahead of Wednesday’s Fed decision given that this story is far from new. Where do we go from here?

It promises to be an eventful and volatile week across forex markets, and substantial Euro and US Dollar risks surrounding FOMC and ECB decisions could make traders especially jumpy ahead of Wednesday and Thursday. There’s risk that Friday’s short-covering EURUSD rally could continue into Sunday and Monday’s sessions, but late-week trends may be decided by outcomes of the two most important central banks in the world. Traders should be wary of pronounced volatility and uncertainty surrounding Fed and ECB decisions. - DR

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