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Two Factors Drive the Euro

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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. As markets increased expectations of higher ECB rates 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 reached a 16-month high. After the ECB signaled it will not raise interest rates as quickly as markets expected 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 2-year German Bund and the 2-year US Treasury. At one point the Bund was trading at a difference of 130 bps. As of this morning the difference has 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 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 the utmost importance that the indebted nation receives additional funding from previously negotiated agreements with the EU/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 a restructuring would be detrimental to the Greek banking system. The ECB is rumored to have 40-50B euros worth of Greek debentures on its books. Recently Junker 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 euro zone. 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 sell-off of the euro in forex trading as well as European fixed income instruments.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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