What Are The Markets Facing?

Price growth at the factory gate in the Euro-zone is anticipated to accelerate even faster in May, as Eurostat is anticipated to report a 0.9 percent rise in the producer price index (PPI). Furthermore, PPI is forecasted to surge 6.7 percent in May from a year earlier, the sharpest increase on record. Indeed, we’ve already seen PPI in Germany (the Euro-zone’s largest economy) jump on the back of record energy costs, and the news will only add to European Central Bank President Jean-Claude Trichet’s already-hawkish tone. Indeed, estimates for Euro-zone CPI have rocketed to a fresh 16-year high of 4.0%, and as a result, the markets are widely expecting the ECB to increase interest rates by 25bps to 4.25 percent on Thursday. This move would mark the first hike since last summer, but given recent commentary, there are indications that this may be a one-and-done deal. Nevertheless, European leaders such as French President Nicolas Sarkozy and German Finance Minister Peer Steinbrueck are staunchly against any sort of rate increase, as restrictive monetary policy threatens to slow expansion in their respective economies to a crawl.

Bonds – 10-Year German Bund Futures

German Bunds continue to consolidate above the one-year lows at 109.66 ahead of Thursday’s ECB rate decision, when the bank is widely expected to hike by 25bps to 4.25 percent. Indeed, the contract pulled back sharply from resistance at 111.54 on Tuesday, despite hefty declines in the German equity markets. Upcoming Euro-zone data may only send Bunds down toward the one-year lows on Wednesday, as the producer price index (PPI) is anticipated to reflect building inflation pressures. However, if PPI is actually softer-than-expected or if risk aversion takes a hold of the markets and sparks flight-to-safety into government debt, Bunds could climb toward 111.

FX – EUR/USD

EUR/USD continues to trade within a wide range of 1.5350 – 1.5800, as the US dollar consolidates across the majors. However there remains potential for an upward swing above near-term resistance at 1.5800 as Euro-zone PPI is scheduled to be released. If figures exceed expectations, the EUR/USD could rally as indications of rising inflation risks would lead the markets to become more aggressive in pricing in a rate hike by the European Central Bank on Thursday. However, if PPI does not rise as quickly as anticipated, EUR/USD could pull back sharply, especially since 1.5800 has proven to be formidable resistance.

Equities – Xetra DAX Index

Germany’s Xetra DAX index shed a whopping 2.2 percent on Tuesday as financials continue to weigh heavily on the market, after Merrill Lynch removed UBS from a list of preferred stocks. Looking ahead, the release of Euro-zone PPI figures has the potential to be market moving. The index is expected to indicate additional upside inflation risks in the Euro-zone, which could weigh the DAX down below near-term support at 6,300 toward 6,250, though sharper declines could target the March lows at 6,168. On the other hand, a weaker than expected PPI reading could help give the DAX a boost toward 6,400.

Terri Belkas is a Currency Strategist at FXCM.