•  ECB shifted toward a more hawkish rhetoric on the back of higher inflation
  •  But an interest rate hike could hurt the periphery = policy headache for the ECB
  •  The Bank doesn't have to actually hike rates for EURUSD to maintain its upward bias

ECB President Trichet's press conference yesterday has been perceived as hawkish by the markets, which helped fuel the euro's staggering rally to above 1.3400 (currently EURUSD is hovering just below 1.3400). But this does not mean that an interest hike is imminent. Trichet said that the current level of interest rates (1%) was appropriate but he continually repeated during that the ECB never pre-commits to an interest rate hike, suggesting that they could raise interest rates if inflation does not moderate.

Essentially, an interest rate hike is not the Bank's central scenario because it believes that prices will moderate and that inflation expectations remain well-anchored. But, the burden of proof lies with the economic data in the coming months. The formula is simple: if Inflation expectations swell then the ECB will hike rates.

This was enough to allow the bulls to have their way with the euro. If we can break above the 1.3405/10 level (the 32.8% retracement of the 1.4200 high to the 1.2900 low) this suggests further gains to 1.3500.

But, yesterday's press conference does not mean that Europe is out of the woods, and all of a sudden sovereign fears have subsided. There is still an awful lot of negative feeling out there towards the euro, and a significant number of people who believe the Eurozone will collapse. Indeed, some of the indebted nations still look weak. Spanish banks are still addicted to ECB funding, borrowing more than EUR66bn in December, after borrowing EUR66.1bn in November. Added to this, Portugal, Spain and Italy still have a hefty debt auction schedule ahead.

The economic divergences within the Eurozone, with a strong Germany and a weak periphery, leaves a policy headache for the ECB.

So where does this leave FX traders?

Essentially the ECB is in a wait and see mode regarding interest rates. The central bank always wanted to pursue an exit strategy, but ended up delaying it because of the sovereign debt crisis. This is unlike the Fed in the US, who is committed to loose monetary policy for the foreseeable future to bolster the economic recovery.

Traders shouldn't try and second guess the ECB and predict when they will hike rates, there are far too many unknowns for that. Instead, relative interest rate differentials are dominating the FX market, which are a good indicator for the currency market.

The ECB don't have to actually hike rates for the upward trajectory in EURUSD to remain, it only has to seem ready to hike interest rates before the Fed. At the moment expectations are shifting toward an earlier rate hike from the ECB than the Fed, which is driving EURUSD strength.

The chart below shows the spread between the euro 3-month swap rate and the US dollar 3-month swap rate and EURUSD. This spread follows the currency pair very closely. Right now it points to further euro strength.

Other indicators point to the same thing: Euribor/Libor spread (interbank lending rates) has less sharp moves compared to the swap rates, but it has also stabilised, which is benefiting EURUSD.

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Recent movements in spreads between Euribor and GBP Libor are also in the single currency's favour and exerting upward pressure on EURGBP.

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Overall, Trichet signalled a shift in rate expectations yesterday, and until we hear otherwise this has halted the decline in the euro. Of course, sovereign issues remain which could cap any gains, but there is still the potential to reach 1.3500 and then 1.3550 - the 50% retracement of the Nov - early January 1.4200-1.2900 down-move.

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EURUSD, with Fibonacci retracement levels and MACD indicator. The daily MACD's bullish crossover suggests further gains for the single currency

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Best Regards,

Kathleen Brooks| Research Director UK EMEA | FOREX.com
d: +44.(0).20.7398 5024 | f: +44.(0).20.7929.2010 | e: kbrooks@forex.com| w: www.forex.com/uk
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