The EUR/USD and the USD/JPY both fell back from 2-month highs to start this week's trading. Traders are cautious at these levels after the sparkling 2-week rally. Investors have been focusing on the steps being taken by European officials to move beyond the current status quo when it comes to the precarious condition of Portugal and even Spain in the sovereign debt crisis.

There has been talk of expanding the role of the EFSF (European Financial Stability Facility) rescue fund - either by letting troubled countries retire debt early using its funds or allow the facility to buy sovereign debt (government bonds) of troubles countries  - similar to what the ECB has been doing (to the tune of 73 billion euros by this point).

These recent talk and the more determined statements by key financial officials - Ollie Rehn, Axel Weber - saying that a deal will be done very soon has excited the markets to this point. Now where do we go from here?

ECB Getting More Cautious on Inflation

European Central Bank President Jean-Claude Trichet warned in a Wall Street Journal interview that the central bank is prepared to respond to inflationary pressures with higher interest rates, despite economic weakness in Greece and Ireland. But he also said that the ECB will not overreact to temporary inflation pressures driven by higher commodity prices. The ECB will look for secondary knock-on effects like increasing wages.

TRICHET: We are profoundly attached to our mandate. And that explains the solid the anchoring of our inflation expectations, which we see as one of our major assets because it helps avoiding second round effects when we have oil price increases in particular. Clearly, in particular on the side of energy and commodity prices we have a number of developments that we will continue to monitor closely.

WSJ: Tighter monetary policy would have the biggest impact on countries like Spain, Greece and Ireland where private debt is linked to Euribor. Can you understand why those peripheral countries are concerned about this hawkish shift?

TRICHET: I also said in my last press conference that the present interest rates were appropriate. In any case all countries in the euro area have an immense stake in the solid anchoring of inflation expectations because medium and long-term interest rates incorporate future inflation expectations.

WSJ: Inflation is being driven by energy and commodity prices and higher value-added taxes in some countries. Is the ECB's focus on headline inflation misplaced? Does the Fed have it right by focusing more on core inflation?

TRICHET: In the U.S. the Fed considers that core inflation is a good predictor for future headline inflation. In our case we consider that core inflation is not necessarily a good predictor for future headline inflation. That being said all central banks, in periods like this where you have inflationary threats that are coming from commodities, have to go through the hump and be very careful that there are no second-round effects. This is what we are doing.

WSJ: When you hiked rates in 2008 there were signs of those second-round effects. Do you see evidence they are starting to take hold in Germany or elsewhere?

TRICHET: At this stage, we do not see this. And everybody knows we would not let second-round effects materialize. We will continue to deliver price stability.

Still, Trichet's comments reinforce the more hawkish tone of the ECB that first emerged earlier this month - after annual CPI rose above 2%.

Macro-economic data was largely positive from Europe, with activity in Germany's private sector accelerating to another four-and-a-half year high, while euro-zone private sector activity also grew at the fastest rate in six months. Euro-zone industrial orders were in line with expectations in November, registering growth of 2.1% on month and 19.9% on the year.

See today's FXTimes post on those here: Euro-zone Data Showing Strong Fundamentals, But Euro Starts Week Lower.

EUR/USD to Retrace?

The market is assuming that some of the anxiety surrounding the euro-zone debt crisis has subsided, but we remain very cautious and with important event risk coming from the US including the Federal Open Market Committee meeting to decide on interest rates on Wednesday and the first estimate of fourth-quarter U.S. GDP due Friday, it does set up the possibility that the current rally reverses and retraces.


That sets up the possibility that the US Dollar could flex its muscles in the second half of the week, especially if the Fed sounds at all more hawkish of if US GDP data comes in stronger than expected. The recent stream of US data has been pretty positive and expectations are for a 3.5% annualized growth rate for the 4th quarter.  That would be up from a 2.6% rate in the 3rd quarter.

While the relief rally for the Euro has been an impressive one, the underlying problems remain that there is uncertainty and instability in regards to some banking centers in the Euro-zone periphery. Even if the immenent fear has subsided, the faultlines are still there. For now traders have been focusing on the positive.

In the US, the economy has been posting stronger data, but it has translated to an increase in jobs. Stronger GDP growth, while a positive needs to go along with better job growth in order to make the recovery sustainable. We'll get a better idea after this week, but anticipating these fundamental shifts can help in this week's trading.