The EUR/USD rose on Sunday as the USD was pressured by S&P's downgrade of its debt as well as the ECB stepping to the plate and deciding to but Italian and Spanish bonds in an attempt to stem contagion.

"European Central Bank President Jean- Claude Trichet signaled he's ready to start buying Italian and Spanish bonds in his riskiest attempt yet to tame the sovereign debt crisis.

In a statement issued in the name of the ECB president after an emergency Governing Council conference call last night, the Frankfurt-based central bank welcomed the two nations' efforts to reduce their budget deficits and said it will "actively implement" its bond-purchase program. It also called on all euro-area governments to follow through on the steps they agreed to July 21, including allowing the European Financial Stability Facility to purchase bonds on the secondary market."

If this helps ease some of the concern in the Euro-zone sovereign debt situation - that the ECB takes the role of lender of last resort until the EFSF is ratified and can do the job, that can inject some ease into the periphery markets and stop some of the contagion experienced by Italy and Spain. Still, the fear that the EFSF rescue fund is too small to save both Italy and Spain will continue to rankle the European periphery bond markets and give the 3rd quarter an important headwind.

EUR/USD Possibilities

In the short term, with the negative fundamental coming from the downgrade for the USD, this positive fundamental developments shifts the fundamental bias to the EUR in the short term.  The EUR/USD gaped higher to 1.4370 at the Sunday open, closed that gap and then returned to that level before falling back again.

EUR/USD Gaps Higher, Tests 1.4370 on US credit downgrade, Trichet Comments

In the hourly timeframe the pair is running up against an important resistance level from last week following several key events:

  1. Thursday the ECB bought bonds, restarting their bond purchase program, but limited their purchases to Portuguese and Irish debt, and not Italy and Spain. The EUR/USD tanked to near 1.4050.
  2. The ECB relented and on Friday, by Italy succumbing to some new measures would have the ECB's support. The EUR/USD rallied back towards 1.42.
  3. Rumors of S&P downgraded the US sends the pair 1.4290 at the close.
  4. Today, we test our highs from last week, and a move higher would target our August 1st highs at 1.4450.

What Next for EUR/USD? Some Possible Scenarios:

  1. Break-Out Rally - If the ECB bond purchases of Italian and Spanish bonds goes over well with the markets, and the US has the overhang of the credit downgrade, the pair can certainly break through recent resistance and head towards a1.4450.
  2. If instead, the rally from Friday's global session needs a retracement, that could be a possibility if risk-off environment begins to favor the USD, or if Euro-zone sovereign debt concerns continue despite the ECB moves.
  3. After this pullback, we can see the EUR/USD entering another rally period, which would first target the 1.4350 area, but then the 1.4450 area.
  4. If risk-off environment gets particularly heavy and we see flight to safety in US Treasuries, we can see a further sell-off in the pair bringing us down to the 50% retracement of the rally from Friday. In this scenario we would see RSI turn downward, and breaks of the 200- and 55-emas (gray and dark blue). This too might present a buying opportunity for EUR bulls.

Nick Nasad
Chief Market Analyst