[Jason_Lim]

Several factors have contributed to the recent euro surge. First, while the euro has probably not greatly benefited from the recovery in risk appetite in terms of direct capital inflows, it has benefited from a reduction in concern over the outlook for the EMEA region. Second, when focus shifts to reflation from deflation, the policy related risks to the USD have come to the fore and the anti-USD has risen. Third, the associated rise in oil prices tends to support the euro as the negative impact on US trade is larger (ie, the Middle East imports more from Europe than the US) and markets believe Eurozone monetary policy will track headline inflation while the Federal Reserve focuses on the core.

Downside risks to the euro
The most immediate downside risk to the euro stems from the potential that investor optimism over the near-term prospects for the global economy is overdone. If the current exuberance were to give way to disappointment, most of the aforementioned supportive factors would likely reverse. In the longer term, the relationship between risk appetite and EUR-USD may shift. Policy stimulus in the Eurozone has been relatively muted, which may lead investors to conclude that the Eurozone economy will take longer to recover than many of its G10 peers. This could prompt equity investor selling of EUR and renew focus on the Eurozone fiscal position if the region proves unable to grow out of the crisis.