We start the week with USD weakness permiating through currency markets while the EUR strengthened on the back of expectations for Thursday's ECB interest rate meeting.
The EUR/USD pair reversed its losses from Friday, showing us that the slide from 1.3830 to 1.3715 may have been more a case of Friday profit taking and squaring positions and we return to our dominant trend the past two weeks of Euro gains. We touched a 3-week high at 1.3854 in NY trading.
The Euro is benefiting from hawkish comments from ECB member Mario Draghi, the head of the Bank of Italy, who said that monetary policy in the Euro-zone is set to be tightened.
From Automated Trader: Speaking at a foreign exchange conference, Draghi, who heads the Bank of Italy, noted that euro area inflation expectations remain well anchored and core inflation is low, given the moderate growth in domestic costs and a cyclical recovery proceeding without any spurts.However, the appearance of inflationary tensions does require that we carefully assess the timing and methods for restoring normal monetary conditions and interest rates, he cautioned. Monetary policy must prevent a deterioration of expectations, in order to keep the stimulus of international prices from passing through to domestic prices and wages in the longer-term.
We have seen several key policy makers - Smaghi and Merch - saying that interest rates may have to be increased in order to contain inflation and so expectations are being heightened ahead of the ECB interest rate meeting and press conference with ECB President Trichet.
In fact at these levels is right where the EUR/USD was prior to the previous rate decision on February 3rd in which Trichet let down markets hoping for a more hawkish tone that he set. That caused the Euro some weakness, but the pressure has only increased from within to consider an exit strategy.
The problem is that while inflation is running at a strong pace (2.3% in January) there is a big disconnect between Germany where the economy is roaring ahead and can cope with higher interest rates an those countries on the periphery - Greece, Ireland, Portugal, Spain - that may not be able to. With the sovereign debt crisis still not in the rear-view mirror what does the prospect of higher interest rates mean for these slower economies?
The fixation on interest rates and the narrowing yield between US and German bunds have given the Euro a distinct advantage in terms of interest rate differential expectations.
You can see the spread between German and US 2-year bonds here:
The Federal Reserve has not made any hints of tightening policy and continues to look for improvement in the labor market before it does so. Until then the US will be a laggard in terms of when it will move to tighten policy which makes it a weaker bet to start this week.
One thing that can help change the dynamic is if February's non-farm payrolls come in stronger than expected. That can start to turn to the tide for the Fed.