The EUR/USD continues to see risk sentiment have the greatest influence on price action as movement in the DJIA is explaining 41% of overall direction. However, U.S. interest rate expectations are starting to increase in importance as they have become a weighing factor with a -0.24 correlation.

EUR/USD

The EUR/USD continues to see risk sentiment have the greatest influence on price action as movement in the DJIA is explaining 41% of overall direction. However, U.S. interest rate expectations are starting to increase in importance as they have become a weighing factor with a -0.24 correlation. Many expect that the Fed will start tightening sometime next year and as we get closer to that possibility traders may begin to hedge their bets developing bullish dollar sentiment. Meanwhile, the ECB has clearly signaled that it will also wait until 2010 before considering tightening which has made yield expectations for the region a non-factor in recent price action.

ECB Interest Rate Expectations

Overnight index swaps are pricing in 87 bps of rate hikes for the ECB over the next twelve months which is near the highest levels since June, 2008. That is when we saw surging oil prices push inflation to uncomfortable levels. Currently we are not seeing consumer prices anywhere near those levels. In fact today's Euro-Zone CPI-estimate unexpectedly fell to -0.3% from -0.2% which is well below the central bank's 2% target. Therefore, policy makers will remain reluctant to initiate a tightening policy unless there is a viable threat of inflation. Until then we may see interest rate expectations have little impact on overall price action for the Euro. The producer price report for August is due out on Friday and is expected to show a 0.4% gain. If businesses are able to pass on their increasing costs to consumers than we may start to see the outlook for monetary policy change and grow in importance.

FOMC Interest Rate Expectations

Fed funds futures are currently pricing in a 2.0% chance of a rate hike by the end of the year which is slightly higher from a month ago. Interest rate expectations have started to rise after they reached as low as zero following the FOMC's rate decision. Nevertheless, policy makers will most likely refrain from raising rates until the economy starts to see job growth. Therefore, this week's U.S. employment data will go a long way toward influencing future policy decisions and their impact of the EURUSD's price action. We have already seen the ADP private jobs report disappoint with a expected job loss of 254K versus 200K. A similar result from Friday's NFP report could significantly sink yield expectations.

Risk

Equity markets stumbled early today on the back of a disappointing Chicago PMI reading which showed that activity in the region unexpectedly contracted. The 46.1 reading missed early estimates of 52.0 and raised questions about future domestic growth. Markets were also unnerved by the larger than expected job loss in the ADP private jobs report which is an early indicator for Friday's NFP report. However, markets have erased earlier losses which could be a bullish sign considering the weak data. Yet, we are starting to see a developing bearish channel which could be a sign of future weakness which could weigh on the EUR/USD.

To discuss this report or be added to the email list contact John Rivera, Currency Analyst: jrivera@fxcm.com