Will the Euro Rally Continue? What to Watch

07/09/2010 12:01 am EST

Focus: FOREX

Kathy Lien

Managing Director and Co-Founder BKForex LLC, BK Asset Management

The euro has come a long way since the beginning of June when it was trading below 1.20. In just under a month, the currency pair strengthened by more than 700 pips. The question now is whether those gains will continue, and in order to answer that, we need to first understand the drivers behind the EUR/USD rally.

Drivers Behind the EUR/USD Rally

1. Less Concern About PIIGS - Concerns about the fiscal situation in countries like Portugal, Ireland, Italy, Greece, and Spain was the main reason why the EUR/USD sold off aggressively in the first half of the this year, and it is also the reason why it has recently recovered. The much-anticipated maturity of the ECB’s one-year lending facility went off without a hitch. Spain was able to attract sufficient demand for its bond auctions, and as a result, credit spreads for the PIIGS have stopped targeting record highs. The stress tests for banks are also due on July 23, and the results should be good because the point of the tests is to restore confidence in the European banking sector. There is word that EU banking regulators could assume a loss of 17% for Greek debt and 3% for Spanish debt, which are not levels that will impress investors.

2. Focus on US - With concerns about the PIIGS easing, the market has shifted its focus to the problems in the US, where economic data has taken a turn for the worse. No US economic reports were released today, but recent data suggests that the recovery in the US economy is slowing. The earnings season begins next week, and there is good chance that the strong dollar had a negative impact on the earnings of multinational corporations.

3. Short Squeeze - Short positions in the EUR/USD hit a record high in May, and when the concerns about the PIIGS started to recede and the focus turned to the US, the rebound in the EUR/USD triggered a massive short squeeze.

What to Watch

The European Central Bank has a monetary policy announcement on Thursday, and there is widespread belief that they will not introduce any new measures before the stress test results are released. However, we will still be listening in closely to the comments made by ECB President Trichet because he may drop hints about whether the monetary policy committee is still considering further monetary stimulus. 

Greece has a T-bill auction next week, and if that goes well, it may provide investors with more confidence to take the EUR/USD higher. The lack of US economic data for the rest of the week means that there will be nothing to change the market’s sentiment towards US dollars. According to last week’s IMM report, there is still a tremendous amount of short EUR/USD positions in the market, which means that as the euro continues to rise, more short positions will be squeezed.

By Kathy Lien, currency analyst, KathyLien.com

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