The euro shot higher despite increasing expectations that the ECB may begin an aggressive easing policy with a rate cut at Thursday’s policy meeting. A gloomy economic report from the E.C. yesterday sent the single currency falling to 1.2539 before it found support. Since then it has been a straight ascent which has the EUR/USD above 1.2750 and climbing. The move may be attributed to increased risk appetite since the region saw factory gate prices decline to 7.9% from 8.5%, which would leave the door open for easing from the ECB.

Inflationary pressures continue to abate, as producer prices dropped 0.2% in September led by declining energy and food prices. The drop in oil prices has been a main factor in the reduction of price pressure, which is now filtering through to other areas as its rise earlier in the year drove broader prices higher. This will allow President Trichet and the central bank to abandon their focus on price stability and lead a significant shift in policy starting with Thursday’s meeting. The one factor that may give the MPC pause is the recent labor strikes from German automobile union workers, since wage inflation is their greatest fear. Regardless, the ECB is expected to cut rates by 50 bps which will limit the upside potential of the Euro.

The Pound has bounced from support at 1.5600 after expectations that the BoE would cut by 100 bps sunk the Sterling. Bullish momentum has the Pound testing 1.5900. The RBS announced a lower than expected write-down of £206 million and a rights offering of 19.7 billion. The news help fuel the growing sentiment that the credit crisis is finally coming to a close, which is evident in Libor rates continuing to fall, which is helping drive risk appetite and the carry trade. Meanwhile, the fundamental picture in the U.K. continues to deteriorate as construction activity fell to a record low. Therefore, expectations are growing that the BoE may cut rates deeper than previously expected and after the RBA surprised with a 75 point reduction the odds have increased.

A relative empty U.S. economic calendar will leave the dollar at the mercy of risk winds. The correlation between the green back and trader’s sentiment has been strong and although there are signs that it may be decoupling, it will remain a determining factor in price action over the near-term. Therefore, the current bout of risk appetite may lead to the continued dollar weakness during U.S. trading. The gauge of September factory orders is expected to show a 0.1% decline in demand which will only add to the dour manufacturing picture. The impact of the credit crunch was evident in yesterday’s dismal manufacturing report; similar results from the service sector and job market latter in the week may prove to be weighing factors for the dollar. Yet the expected decline in interest rate differential between the U.S. and other countries will remain a supportive force which has been a main driver of recent bullish dollar sentiment.

David Rodriguez is a Currency Analyst at FXCM.