Over the past few days there has been much speculation about what has been (and what will be) the future drivers of the euro.

For most of the past year the chief driver has been a positive yield differential and a collapse in the dollar. However, it seems increasingly unlikely that we can rely on these two drivers going forward.

Correlation analysis gives you a quick snap shot of how things have changed for the euro. Since the start of this month its two most important drivers have been 1, the S&P - with a 79% correlation - and 2, the two year German bond yield at 70%. In contrast, Euro swap rates (a good indication of short term interest rates) have lost significance as a driver.

Both German bond yields and stocks are closely aligned with risk appetite: stocks have collapsed as risk has sold off, bond yields have fallen as German government debt has attracted safe haven flows, which has dragged the euro lower.

So what does this tell us?

  •  The single currency is moving with risky assets. It has a negative correlation with the Vix - Wall Street's ultimate fear gauge - which is now at 82%, compared with an insignificant 53% back in February.
  •  Currently the outlook for interest rates in the euro area is only important for the euro if it impacts risk - i.e, if a dovish ECB boosts risk appetite then we could see the euro rise even as yield expectations fall.
  •  The positive tone towards risk assets in recent days is completely reliant on 1, the EU authorities agreeing on a radical plan to extend the EFSF fund to the tune of EUR2/3trillion, 2, a recapitalization of the banks and 3, an orderly default for Greece. This is a tall order and the EU authorities have a history of underperforming and dashing market expectations causing bouts of market turmoil.
  •  Thus, while the euro moves in a pack with risk, expect volatility ahead.

But this sell off in the euro has some crucial differences with the decline in early 2010. Although the Eurozone debt crisis has notched up a few gears the most recent fall in the euro from 1.4500 to 1.3500, is small in comparison to the decline to 1.1800 last year during the first Greek default.

This tells us a couple of things:

1, There could be further to go if the EU disappoints on its latest rescue plan.

2, The long-term flows like central banks/ institutional investors etc that have also helped to support the euro in recent months have not ditched the single currency yet.

In conclusion, the euro is vulnerable to risk sentiment and is likely to trade in a range with a negative tone for some time yet (or until the sovereign debt crisis is solved in a sustainable way).

Interest rates will only impact the euro in as much as they affect risk appetite. Looser monetary policy from the ECB is likely to be more positive for risk, so expect an inverse yield effect for the euro in the short-term: thus, a reduction in rate expectations (as measured by euro swap rates) may cause a boost to the euro. However, rising German bond yields are also euro positive since German bonds are acting like a safe haven asset. Any sign that long -term investors are getting nervous of holding euro would be extremely negative for the single currency.

The euro is moving with risk. EURUSD (white line) and Vix index (orange line). NB: The Vix moves higher when there is a slump in risk appetite.

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Kathleen Brooks| Research Director UK EMEA | FOREX.com

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