EUR/USD Analysis: Euro short-squeeze or dollar sell-off?

Today, the calendar of economic data is quite robust. In Europe the industrial production data and the ZEW economic sentiment survey will be published. Markets usually give more weight to the PMI’s and the IFO release, which will be published later this week. So, we expect the impact of the ZEW survey on currency trading to be limited. A reaction to this indicator would tell us more on underlying market sentiment than on investors’ assessment on the economy.

In the US, the retail sales report remains an interesting piece of information on the status of the US economy. The producer prices are probably less relevant for EUR/USD trading. Over the previous days, currency traders didn’t really know to which factor they should focus on. Sometimes, higher US bond yields were seen a good reason to buy dollars. Yesterday, improved risk appetite was again seen a good enough reason for a scaling down of EUR/USD shorts.

In addition, the dollar showed some signs of fatigue on the rally that had occurred for most of last month. So, the jury is still out which card markets will play going forward. Will the dollar gain or lose in step with the incoming US data and the subsequent reaction on the bond markets?

If so, the dollar should profit from stronger than expected US retail sales. Or will the risk story prevail/return? Last but not least, the upcoming EU summit might still complicate the euro side of the story. So, there are a lot of conflicting issues that might interfere in EUR/USD trading. Given thin end of year market conditions, this might trigger more erratic swings as the one we attended yesterday. After the close of the European markets, the Fed will announce its policy decision.

After last month’s ‘big move’ to QE-2 and as the global picture for the US economy hasn’t really changed since the previous meeting, we don’t expect the Fed to bring any high profile message for markets.

EUR/USD on Monday

On Monday morning, EUR/USD trading took a slow start of the new week and it looked as if EUR/USD traders should have prepared for an uneventful trading session.

There were no economic data on the calendar in Europe and neither in the US. EUR/USD reached an intraday low in the 1.3185 area late in Asia as the dollar continued to profit from higher US bond yields. However, a real test of last week’s low didn’t occur and EUR/USD found a better bid early in European trading.

The positive sentiment on the equity markets gave the euro downside protection. However, trading was in the first place order-driven and developed in thin market conditions. EUR/USD had reversed the Asian losses when US traders joined the fray. Even more, the euro short-squeeze accelerated during the US trading hours.

Rating agency Moody’s said that the US tax and unemployment benefit package of last week will increase the likelihood of a negative outlook for the US AAA rating in the next two years. The statement of Moody’s was also no help for the US dollar which was already in the defensive at that time.

In addition, US yields nosedived as Treasuries reversed part of their recent losses. All this apparently forced some short-term players to backtrack on USD long positions. Thin market conditions exacerbate the intra-day price swings.

EUR/USD reached an intraday high at 1.3434 in US afternoon trade and closed the session the session at 1.3391, quite an impressive gain compared to the 1.3226 close on Friday evening.

We see yesterday’s move in the first place as a technical short-squeeze in thin market conditions. So, we don’t make too much out of it yet. Nevertheless, the move might also contain a warning that the US currency is not completely immune to fundamental weaknesses in the US economy or its policy framework.

The institutional deficits of the euro zone are well documented and have got ample coverage in the (Anglo-Saxon) press. They were (and still are) a good excuse to sell the euro when political bickering among European policy makers returns into the spotlights. However, at school we learned that the combination of a loose fiscal and monetary policy at the same time might undermine confidence of foreign investors at some point.

Maybe US bonds and the US currency are also not completely immune for this mechanism.

Content provided by: KBC Bank