It is going to be an interesting week for the Euro, as several factors are converging and pulling at the common currency in different directions.
While usually, political turmoil would hurt the EUR against the USD and looks to have dented the EUR to start the week, the resulting higher oil prices can actually benefit the EUR once the unease and investor sentiment around the immediate situation dies down.
The reason being that higher oil prices will feed through to higher inflation and will support more talk of higher interest rates as the ECB acts to counter the inflationary impact of higher oil. While ECB President Trichet tried to temper expectations about rate hikes only a week or so ago, suggesting that the market had priced in the ECB moving earlier than may be warranted, we had that sentiment knocked back on comments from Lorenzo Bini Smaghi, who has spent the last few days warning of the likely permanent rise in food prices and the need to take a preemptive strike against inflation. Therefore, higher oil prices will contribute to higher commodity and food prices as it makes it more expensive to ship goods around.
The speculation around ECB rate hikes was also helped by very strong data in Germany where the IFO Business Climate index rose to a new all-time high this month (111.2 from 110.3), and the preliminary version of the Manufacturing (up to 59.0 from 57.3) and Services (57.2 from 55.9) PMI's came in much higher than anticipated.
As fears of higher inflation rise, they may outweigh the continued concerns about the sovereign debt crisis. If that continues to be the market's main focus then it will expect the ECB to concentrate on keeping price pressures in check rather than curbing funding costs for the peripheral debtors that still remain at risk. We saw the theme of interest rate expectations dominate the past few weeks of trading in our major currency pairs as traders try and price in which central bank will raise rates when and by how much.
On the other hand, we do have some new fissures in the sovereign debt crisis, and focus may once again turn to the problems there, keeping the EUR pressured in the near term. Bond yields in Portugal continue to rise, with the 5-year bond yield now climbing above the psychologically important 7% level. Last week we learned that EU member states are pressuring Portugal to take a bailout, as the writing seems to be on the wall that they will not be able to sustain such high borrowing costs much longer.
While a Portuguese bail-out may be a foregone conclusion to the markets, such a development would still rattle the EUR, though not as much as the turmoil following Greece and then Ireland. That is because the impact on the market of bailing out these smaller countries is lessening. When Greece was bailout out the EUR fell to $1.20, but dropped only slightly below $1.30 following the Ireland bailout. We currently trade near 1.3650.
However, the problem comes when the market asks who's next? and points their fingers at Spain. The current rescue fund the European Financial Stability Facility (EFSF) is not big enough to rescue such a big country as Spain.
Therefore its important to see how politicians come together to either increase the size or expand the scope of the EFSF though the expected overhaul may not meet expectations.
With political turmoil in the Middle East and North Africa and provocative moves by Iran vis-a-vie Israel, there is still uncertainty about risk appetite which is likely to help boost the JPY and CHF at the expense of the EUR.
But as I have laid out here, beyond the short term, which major theme wins out - sovereign debt concerns or interest rate differentials? That will decide the fate of the EUR for the next few weeks.
For a technical analysis look at the EUR/USD pair please see today's Technical Update: EUR/USD Pauses Rally Near 1.3720, 61.8% Retracemen