2 Factors Driving Euro Pricing

05/30/2011 5:00 am EST

Focus: FOREX

An insightful look at how the global interest rate picture, and most notably, the return of the European debt crisis, is impacting euro pricing against major currency counterparts like the US dollar.

There are two major factors driving the value of the euro: Interest rate differentials and the European debt crisis. At this stage, only the debt crisis is having an impact on forex trading.

Since January, gains in the euro have largely been driven by interest rate differentials between Europe and the US, with Europe in the process of moving European rates higher. At the same time, the US was in the process of easing monetary policy via its second quantitative easing program (QE2).

As markets increased expectations for higher rates from the European Central Bank (ECB), the value of the euro increased accordingly. With US monetary policy forecasted to remain in a state of providing the market with high levels of liquidity, the EUR/USD currency pair reached a 16-month high.

After the ECB signaled it will not raise interest rates as quickly as the markets were expecting, the EUR/USD came off of this high.

One way to view the different interest rate differentials is to track the yield difference between the two-year German Bund and the two-year US Treasury. At one point, the Bund was trading at a difference of 130 basis points (bps). At the time of this writing, the difference had shrunk to 118 bps.

This data point drives home the previous factor that was supporting the euro since January; interest rate differentials.

A new, yet familiar theme is now the leading factor in the movement of the EUR/USD: The European debt crisis. Tensions are building as Greece’s sovereign credit rating was cut multiple levels by ratings agency Fitch.

Greece looks to be unable to reach its proposed budget deficit target of 7.5% of GDP. Reportedly, Greece only has enough cash on hand to prevent a default until mid-July. This makes it of the utmost importance that the indebted nation receives additional funding from previously negotiated agreements with the EU/International Monetary Fund (IMF).

Speaking last week, ECB executive board member Jürgen Stark said the ECB would cease to accept Greek bonds as collateral for loans to Greek banks should Greece choose to restructure its sovereign debt. Stark was quoted as saying, “Sovereign-debt restructuring would undermine the eligibility of Greek government bonds.”

Earlier comments last week from EU officials warned that a restructuring would be detrimental to the Greek banking system. The ECB is rumored to have EUR40-50 billion worth of Greek debentures on its books. Recently, the ECB’s Juncker proposed a re-profiling of Greek debt that would extend Greek maturities based on a mutually agreed extension.

Concurrently, Italy and Belgium were hit with a series of ratings downgrades, adding a string of negative sentiment to the Eurozone. Elections in Spain have also brought the market’s attention back towards one of the larger European economies.

The risk for the euro is a failure of EU authorities to contain the Greek debt crisis while avoiding a contagion effect and a downturn in investor sentiment. Such a scenario would bring a selloff to the euro as well as European fixed-income instruments.

By Russell Glaser of ForexYard.com

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