Euro Observations

I have been skeptical of the euro's rally in recent weeks, fueled by a shift in interest rate expectations and confidence that European officials are going to come up with a "comprehensive plan" to arrest the more than a year old debt crisis. However, there have been few signs that selling the euro was a low risk venture. Today could very well be the turning point.

Two market indicators in particular are flashing important warning signs the dollar bears. First and most important, Trichet's comments have prompted a sharp decline in short-term European rates. The 2-year German rate has fallen 11 bp, while the US 2-year yield is up 4 bp. This swing has resulted in a sharp move in the 2-year differential, which we find tracks the euro-dollar exchange rate fairly closely. That spread is now at about 69 bp in Germany's factor, which is the lowest since early last week. Yesterday the spread was over 83 bp. We find the change is more important than the level. For the record, at Trichet's press conference last month the spread was about 23 bp.

The other market indicator is the risk-reversals, which measure the pricing difference between puts and calls equidistant from the forward strike. In both late '09 and late '10, the premium for euro puts over calls began growing a couple of weeks or so before the euro began to weaken in the spot market.

A similar development seems to be taking place now. Since Jan 14, the premium for euro puts has been trending higher even though the euro has been making trending higher. Currently, on the three-month risk reversal is showing about a 1.70% premium for euro puts. This is close to the largest premium in several weeks.

$1.3590-$1.3620 appears to be initial support and then a cent lower. At the same time, however, with US unit labor costs falling 0.6% (market expected a 0.2% increase) Bernanke cannot be expected to signal a shift in QEII. Moreover, strong economic data can be dollar positive IF it operates through the interest rate differential channel.
Euro Observations Euro Observations Reviewed by Marc Chandler on February 03, 2011 Rating: 5
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