Beware Steeper EUR/USD Correction

For the first time in 10 trading days, the euro weakened against the U.S. dollar. While the sell-off in the EUR/USD was caused by political uncertainty in Spain, even without the calls for Spanish Prime Minister Rajoy to resign, the currency pair was due for a correction. The European Central Bank has a monetary policy meeting this week and while their message is not expected to change, it will be difficult for Mario Draghi to avoid talking about the currency.

Over the past two months, the EUR/USD has risen nearly 7% and while we know that the central bank is comfortable with the EUR/USD between 1.34 and 1.36, the question is whether the recent rally has happened too quickly and if the central bank is worried about a 1.38 to 1.40 currency value. The EUR/USD is currently near its long term average, so we do not expect Draghi to call the move "brutal," a term used by Trichet in 2004 and 2007 to cap the gains in the currency. At the time, investors interpreted brutal to mean that the central bank was ready and willing to intervene in its currency. Draghi has three choices this week -- he can brush off the currency's recent move and say they are not worried, which would be extremely positive for the euro. He can also say, "excessive exchange rate moves are undesirable," which is not as powerful as calling the move brutal but would send a clear message to the market that the ECB is not satisfied with the recent move in the currency. Trichet used some version of the "excessive exchange rate" comment in 2008, 2010 and 2011 but unfortunately it did not curtail the gains in the EUR/USD nearly as well as the word brutal. The best answer that Draghi can give is to "no comment" on currency questions but the market would probably interpret that to mean continued comfort with the current EUR/USD level. The head of the European Central Bank probably won't discuss the currency in his prepared commentary but reporters will jump at the opportunity to ask him about the euro. As a result, traders should beware of a deeper correction in the EUR/USD this week ahead of Thursday's central bank meeting.

European stocks and bonds are also down sharply this morning. The steepest losses were seen in the Spanish markets with the IBEX down more than 2% and 10-year bond yields up nearly 20bp. Spanish Prime Minister Rajoy is embroiled in an alleged illegal cash payment scandal that has led to widespread calls for his resignation. With the euro-zone's recovery still in its infancy, political uncertainty isn't good for the currency.

Meanwhile the dollar is mixed today because there isn't much in the way of U.S. data this week. USD/JPY climbed to a fresh 2.5-year high above 93 at the start of the European trading session but has since turned negative. The dollar is also trading lower against the British pound, Australian and New Zealand dollars but higher against the euro, Swiss Franc and Canadian dollar. Factory orders increased 1.8% in December, which was a smaller recovery than anticipated but a significant rebound from the 0.3% contraction in November. Between the 0.5% miss and the downward revision to the prior month's report, manufacturing activity fell short of expectations at the end of the year.

Kathy Lien, Managing Director of FX Strategy for BK Asset Management