Euro Re-couples with Risk

EUR/USD sunk almost 200 pips overnight as concerns that European banks are at risk as they hold more potential toxic sovereign debt than reported in the recently performed stress tests. As Europeans rebel against austerity measures aimed at bringing unruly budget deficits under control, the path toward fiscal soundness has become thorny, increasing the potential for defaults.

EUR/USD

The EUR/USD sunk almost 200 pips overnight as concerns that European banks are at risk as they hold more potential toxic sovereign debt than reported in the recently performed stress tests. As Europeans rebel against austerity measures aimed at bringing unruly budget deficits under control, the path toward fiscal soundness has become thorny, increasing the potential for defaults. Markets had started to price in the potential for an ECB rate hike before the policy makers pointed toward remaining on hold until the end of the year following the latest rate hold. Interest rate expectations have increased in influence in determining price action with the correlation rising to 54%, but fresh bank balance sheet worries could diminish the importance of the outlook for yields. Risk trends could once again become the primary driver of price action as the pair has re-coupled with stocks, with the relationship strengthening to 50% from 45% a week ago.

ECB Interest Rate Expectations

The ECB extending their emerging lending program for banks until the end of 2010 has sunk yield expectations for the region. We can see the sharp shift in sentiment in overnight index swaps which went from pricing in 35 bps in tightening to 28 bps following the announcement. Markets had started to gear up for a potential first quarter rate hike following a slew of improving fundamental data led by strong German growth and an improving labor picture in the Euro-zone’s largest economy. Concerns over the banking sector have resurfaced which could diminish the impact of future releases. However, the central bank may have provided a veiled forecast for a rate hike by defining a potential end date to liquidity efforts. If markets adopt this view then continued signs that the recovery is sustaining may lead to a brighter outlook for yields and Euro support. Upcoming German export data and next week’s release of the Zew survey are the only potentially market moving events on the horizon which could leave the pair at the mercy of risk trends in the short-term. Discuss this and trading ideas join the EUR/USD forum.

FOMC Interest Rate Expectations

Despite unexpected manufacturing growth and consistent private jib creation, the Fed is expected to remain on hold through the end of the year. The soonest that markets see any chance of a rate hike is in January where Fed fund futures are pricing in a paltry 1.0%. The Fed Beige book release will provide regional insights into the economy but doesn’t have hold the same weight as the labor report. Therefore, we don’t expect the outlook for yields to improve anytime soon, maintaining the dollar safe haven status. Therefore, if European banking concerns continue to grow, the EUR/USD could falter as the greenback benefits from the flight to safety.

Risk

Stocks are on the verge of ending a week long advance as concerns over European debt has led to a bout of profit taking. There is very little on the fundamental calendar that could drive demand for risk which could leave price action at the mercy of the broader trend. We could see an ultimate test of the descending trend line before an ultimate bearish reversal as a broader triangle pattern is beginning to form. Discuss this and other fundamental data in the Economics Forum.