Forex Investment and Currency Trading

There had been a correlation between movements in EUR/USD and the price of crude oil, although the dynamics driving that relationship appear to have shifted. Over the last 6-12 months it appears an asymmetric response function among major central banks to movements in oil prices that may have contributed to the correlation between EUR/USD and the oil price. Given rising headline inflation in the Euro zone and the ECB’s sole mandate of inflation control, rising oil prices were viewed as an upside risk to inflation. For the Fed and its dual mandate, however, rising oil prices marked an upside inflation threat but also was a significant downside risk to growth, particularly as economic momentum has weakened in recent months. In this context, rising oil prices are likely to contribute to a narrowing of expected interest rate differentials between the Euro zone and the US, a relationship that has been relatively strong over the last 18 months.

In this context, we can say the EUR is in a topping process with significant downside risks during the months ahead. With the surge in EUR denominated oil price during 2Q 2008 combined with tight overall monetary conditions, the downside risks to Euro zone growth are likely to become more visible during the months ahead. A particular turning point could be reached this week with the release of preliminary PMI data for July for a number of Euro zone economies. Through June only Germany maintained an expanding manufacturing sector and there appears a risk that even the German PMI could dip below 50 in July. In this context, this week could mark the beginning of an important shift in expectations about future ECB policy, with weakening growth prospects and lower oil prices leading markets to price out the 80+% probability of another ECB rate hike by year end. As a result, it is viewed that the recent EUR/USD surge above 1.60 marked the end of the long cycle higher and
short EUR/USD trade is recommended.