How Much Further Can the EUR Rise?

Sorry for the radio silence – have been on vacation then corporate craziness

The euro staged a remarkable rally today after dipping as low as 1.4060 following the U.S. non-farm payrolls release. The resilience of the single currency is incredibly impressive considering that Standard & Poor’s downgraded Ireland’s sovereign debt rating and Fitch warned about the possibility of their own downgrade in the near future. Both rating agencies currently have Ireland at the same level but a downgrade by Fitch would move Irish debt one step closer to junk.

However none of these rating actions have deterred forex traders from buying euros in anticipation of the first rate change in nearly two years. At the last monetary policy meeting in March, ECB President Trichet said interest rates could be increased as early as April. Since then, the central bank’s message has been very consistent with a number of ECB officials reiterating the need for tighter monetary policy. In contrast, the Federal Reserve is still debating whether QE2 should be cut short. Although many members of the Federal Reserve have grown more optimistic, there are also a number of Fed officials who believe that caution is warranted.

As a result, the best that we can expect from the Fed won’t nearly be as hawkish as the least that we can expect from the ECB. The better than expected U.S. non-farm payrolls report on Friday helped to lift the dollar against the euro but we believe that the EUR/USD could make a run for fresh year to date highs ahead of the ECB’s rate announcement on Thursday. The direction of interest rates is one of the most important drivers of currencies and investors usually prefer to invest in currencies where the interest rate is high and growing and the euro certainly fits the bill. Aside from the ECB rate decision, Eurozone retail sales, German factory orders, industrial production and the trade balance are also scheduled for release. Baring any major downside surprises, the euro should be on its way to a new year to date high. After the rate decision however, the euro could weaken if a classic buy the rumor, sell the news dynamic takes hold.

This chart shows how rate hike expectations have changed in recent weeks:

In terms of how high the EUR/USD can rise, there is a VERY good chance that the currency pair will make a run for its Nov high of 1.4282. If this level is broken, then it could be clear sailing to 1.45

100bp of Tightening Priced in for ECB?! See Latest G7 Rate Hike Expectations

Rate hike expectations are always changing and its important to keep track of them because they reflect what investors are pricing in.

Here are the latest numbers and highlights (compared to last week)

Fed – One 25bp rate hike expected by Q1 2012 > Minor increase in implied policy changes
BoE – 50bp rate hike priced in for this year > compared to only 25bp last week
ECB – Nearly 100bp price in for this year compared > compared to only 50bp last week
RBA – Rates expected to remain unchanged this year
RBNZ – One rate hike in March 2012 down > no changes
BoC – 50bp by Feb > increase in rate hike expectations compared to last week

EUR/USD Headed for 1.40 after ECB?

The EUR/USD ripped higher after ECB President Trichet telegraphed a possible rate hike next month. The rise in oil prices has hit a cord with the central bank, prompting them to step on the accelerator and get moving with curbing inflation pressures. Not only did Trichet use the magic words “strong vigilance,” but to remove any uncertainty, he said point blank that “Vigilance means rates may rise next month , increasing rates in April meeting possible.”

Regardless of how much Trichet tried to tone down this comment later on by saying it is not appropriate to expect a “big rate move,” and they are not ready to embark on a “series of rate hikes,” the mere prospect of a rate hike is very positive for the euro. Even if the EUR/USD does not take out 1.40 today, it should just be a matter of time before it does so. Based upon Fed Chairman Ben Bernanke’s comments earlier this week, the U.S. central bank is still straddling the fence in terms of normalizing monetary policy. In contrast, the ECB has sent a very clear signal to the market that rates will increased over the next 1 to 2 months. This dynamic should cause the dollar to continue to underperform against the euro.

The race is now between the ECB and BoE and the way its looking, the ECB could be the next central bank to raise interest rates. The central bank upgraded its inflation forecast for 2011 to 2.0 – 2.6% from 1.3-2.3% forecast in Dec and their 2011 GDP forecast to 1.3-2.1% vs. 0.7-2.1%.

Why the ECB is Still Hawkish

ECB President Trichet’s lack of commitment towards future monetary policy has led to little volatility in the Euro. After leaving interest rates unchanged at 4.25 percent, Trichet explicitly said that he has “no bias.”

Trichet However based upon the number of times he used the words “price stability in his Introductory Statement, he is still hawkish. Compared to last month’s statement, Trichet used price stability two more times this month. Although he acknowledged that growth is slowing, he reminded Euro traders that inflation is still their top priority. We shouldn’t forget that they only have one needle in their compass and that is delivering price stability.

Oil prices have fallen significantly since August but Trichet is very adamant about inflationary pressures because of wage negotiations. The ECB’s greatest fears is that unions in Germany would use inflationary pressures as an excuse to hike wages. This a problem that separates the Eurozone from the US. Wages in the US have been steadily declining on an annualized basis.

There is still more trouble for the Eurozone economy as factory orders dropped for the eighth month in a row but the hawkish tone of ECB President Trichet should lead to a further recovery in the Euro especially as US non-farm payrolls face the risk of falling by -100k.