*The peripheral debt crisis:*
The euro has made an impressive come-back after faltering at the start
of the week. Yesterday the single currency rose nearly 2 per cent,
which leaves a breach of 1.3500 in view that would herald more gains.
Interestingly, this has come at the same time as EU leaders have
failed to come up with a credible long-term solution to the sovereign
debt crisis , instead holding off on any decisions to extend the EFSF
rescue fund until March, with a fresh round of bank stress tests not
due until July.
Interestingly, EURUSD has been rallying at the same time as Portuguese
bond yields have risen above the crucial 7 per cent level that is
deemed the threshold whereby Portugal would require a bailout, as you
can see in the chart below. Yields and the euro moved in the same
direction until the end of last year, when Portuguese yields rose as
the euro sold off. Since then yields have risen as the euro has fallen
as investors sold the single currency on the back of sovereign debt
fears.
EURUSD (orange line) and 10-yr Portuguese government bond yields
*So why is the euro rising at such a critical time for the Eurozone?*
There are three reasons for this:
Firstly, most risky assets are rallying. Stocks are at a cyclical high
and this is dragging the euro ( part of the risky FX pack) higher. The
bullish atmosphere in the stock market is dominating investor
sentiment so that fears about a potential bailout of Portugal have
taken a backseat.
Secondly, Germany's economic rebound is continuing into the new year.
Yesterday we saw strong investor confidence. The forward looking
component of the ZEW index rose to a 5 month high, smashing market
expectations. Germany is the largest economy in the currency bloc, so
its strength will boost Eurozone economic data in the first quarter.
The fact that the euro staged a strong rally post the strong ZEW
figure yesterday suggests that the euro is trading like the
Deutschmark, which is what we saw prior to Ireland's debt crisis
coming to a head back in November 2010– see chart below.
10-yr Irish government bond yields (white line) and EURUSD – bond
yields rose along with the euro in the lead-up to Ireland's bailout.
Lastly, part of the euro's strength could be down to investors
clinging to hope that the Eurozone's leaders can find a solution to
this crisis. Although there will not be an immediate boost to the EFSF
fund, or the introduction of euro-wide bonds, which are considered by
many to be the only way out of this crisis, investors are still giving
the currency bloc the benefit of the doubt and expect it to muddle
through to a solution at some point this year.
*Fundamental euro drivers also in place:*
While all of these reasons are supporting the single currency there
are more fundamental supports that also point to further euro
strength. The 3-month euro swap rate is sharply higher, although it
may have made a top in the past day (yellow line on chart below) . On
top of this the Euribor/ Libor spread (Eurozone/ US inter-bank lending
rates respectively)has started to widen again after narrowing in
recent weeks (orange line on chart), which is euro positive. Overall
then this extra "yield" is helping to boost EURUSD (white line on
chart).
Euro 3-month swap rate, EURUSD and Euribor-Libor spread, normalised,
to show how all three move in line with each other.
*However, there could be some volatility ahead:*
Even if the general trend is higher for the single currency, it may be
a bumpy road ahead due to the ongoing threat of a sovereign crisis
shifting investor sentiment. Above 1.3500, the next key resistance
level is 1.3685, then 1.3980 – 200-week moving average, before 1.40.
Below 1.3500, 1.3415/20 should hold as good resistance if the euro's
upward trajectory is to be maintained.
EURUSD daily chart, along with MACD daily indicator, which has also
turned bullish.
Source: ActionForex.Com
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