FOREX ANALYSIS

The euro has been one of the best performers in the G10 this week. Although, sovereign debt woes persist and Portugal is on the cusp of a bailout, the single currency's resistance is is particularly impressive. We think this is all down to Spain.

• Spanish bond yields support euro strength

• Euro moves more in line with short term interest rate expectations, not longer-term rate expectations

• Euro benefitting from ECB being first of the major central banks to bite the bullet and hint they will hike rates next month ]

• EURCHF not moving with interest rate differential, this cross is driven by risk sentiment

As the chart below shows – Spanish bond yields have fallen relatively sharply since reaching a peak earlier this month. The move lower in Spanish bond yields has coincided with the leg higher in the euro to the 1.4150-1.4200 level.

Spanish 2-year yields and EURUSD (purple line)

So…..

• The euro is ignoring the impact of a Portuguese bailout (rumoured to be EUR70-80 bn), because in the big scheme of things this is pocket change for an economy that generates GDP of more than EUR 11trillion a year.

• Also, even though there has been some wrangling over the detail of the long-term ESM facility, the key thing for investors is that Germany and to a lesser extent France are standing behind the ESM and are willing to do all they can to protect the euro.

A triumvirate of positive influences on the euro:

• ESM decisions taking the pressure off the periphery’s long-term financing constraints

• Expectations of rate increases by the ECB

• General risk rally

In an environment of low yield the positive interest rate differential in the Eurozone is key support for the euro.

Earlier this week I looked at the spread between 1-year euro swap rates and 3-month euro swap rates and noticed that it had been narrowing in recent weeks. Although markets have been reducing their expectations of long-term rates in the Euro-area in the past couple of weeks the market is not focusing on this.

So what is driving the euro?

Short-term rate expectations are the key driver of the single currency right now, while longer term rate expectations take a back seat. The ECB remains willing to bite the bullet when neither the Fed, BOE or SNB seem willing to do so. So the single currency is benefitting from the fact the ECB is the first central bank to get off the blocks.

Euro 3-month swap rates – 3-month Fed Funds Futures (white line) and EURUSD – clearly supportive of further EUR strength, possibly to the 1.4250 then towards 1.4450 and 1.4500.

Likewise, EUR 3-month swap rates and GBP – 3-month swap rates point to strong EURGBP. The euro is benefitting of the erosion of UK rate expectations, the pair had a giant leap higher yesterday to 0.88 and should close the week nearly 1 per cent higher. Above 0.8800 the pair may take a breather in the short-term, but we think that the bias is for stronger EURGBP and the pair could breach 0.9000 in the coming weeks.

While the German/ Swiss bond yield spread points to a stronger EURCHF, the single currency has found it harder to rally against the Swissie. This cross actually moves more in line with risk sentiment (Vix is red line on chart). The Swissie is boosted by safe haven flows (when the Vix spikes) and the euro does welll when risk aversion falls. Hence the Vix has come off this week and EURCHF has moved higher.

As long as risk appetite remains supported then we could see more EURCHF strength. EURCHF is testing 1.2940 – 100-day moving average. Above here we may teest 1.3170 – 200-day moving average and a key resistance level.

PLEASE NOTE THAT THE PRICES IN THESE CHARTS DO NOT REPRESENT FOREX.COM PRICES. (CHARTS: BLOOMBERG CHARTS)

Kathleen Brooks, Research Director UK