A couple of things to note as we start the week:

  •  The dollar is shunned by investors
  •  Sovereign debt crisis is back in focus.

Dollar:

The market is holding a record amount of dollar shorts according to the latest positioning data. The largest short dollar positions are against the CAD, AUD, CHF and the yen.

But EURUSD long positions are back to their October 2010 highs when EURUSD was above 1.4200, and although long GBP positions have come off their peak, they still remain at 2008 highs.

The dollar is under pressure on a broad-based basis. The dollar index is close to a pivotal level: below 76.30 we could see back to 76 then to the 10-year low of 72.00.

These big technical levels warrant caution. While the downside pressures continue to threaten the dollar, including a high oil price and QE2, stretched positioning in one direction increases the chances of a reversal especially since we have seen an improvement in the US economic outlook.

But there is one caveat: we still don't know what growth in the US will look like without Fed stimulus. We won't know that until the second half of the year after QE2 ends in June (as long as there is no QE3). So a dollar rebound may take longer in this environment.

Dollar index - weekly chart

width=630

The euro: trading like the deutschmark

Although Greece was downgraded today and Irish 10-year bond yields reached a record euro-era high, EURUSD continues to trade with a strong bias, only flinching when Moody's, the credit rating agency, made its announcement on Greece.

The chart below shows the single currency higher along with the cost of borrowing for Europe's troubled peripheral nations relative to German 10-year bond yields.

Ireland -German 10-year yields (white)
Portuguese -German 10-year yields (orange)
Greek-German 10-year yields (yellow)
Spanish-German 10-yr yields (green)
EURUSD (purple)

width=630

So what does this tell us:

 

  •  The euro is like the deutschmark
  •  As the threat of a Spanish bailout recedes investors are happy to buy the single currency

 

The euro is essentially trading like the deutschmark and has been rising in line with Germany's safe haven status and its strong economic recovery. It has also been trading higher as the spread between Spanish and German yields has moderated as fears about a Spanish bailout have receded.

Europe's sovereign debt crisis has been mainly played out in the credit markets and not the currency markets, so in that sense the single currency has been a success, as fx volatility has been fairly minimal during the crisis.

But this week is crunch time for the Eurozone. Thursday's summit of EU leaders will discuss policy proposals to tackle the Eurozone debt crisis. Expectations have been scaled back in recent weeks, as EU leaders seem less willing to adopt the more radical proposals for the EFSF rescue fund including direct sovereign debt purchases or a dramatic increase in the fund's size.

Now that the heat has come off Spain - the largest peripheral economy that was in danger of a financial crisis - the chances are that they will only agree to increase the fund by a more reserved EUR440bn.

While Europe's problems are far from over, the single currency is being driven higher by German economic might and the accompanying hawkish stance taken by the ECB last week.

If the euro can maintain its strength this week then we would expect to see the divergence in FX and credit markets continue and the euro to do well even if Ireland, Greece and Portugal continue to suffer.

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Best Regards,

Kathleen Brooks| Research Director UK EMEA | FOREX.com

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