The euro staged a remarkable rally today after dipping as low as 1.4060 following the U.S. non-farm payrolls release. The resilience of the single currency is incredibly impressive considering that Standard & Poor’s downgraded Ireland’s sovereign debt rating and Fitch warned about the possibility of their own downgrade in the near future. Both rating agencies currently have Ireland at the same level but a downgrade by Fitch would move Irish debt one step closer to junk.

However, none of these rating actions have deterred forex traders from buying euros in anticipation of the first rate change in nearly two years. At the last monetary policy meeting in March, ECB President Trichet said interest rates could be increased as early as April. Since then, the central bank’s message has been very consistent with a number of ECB officials reiterating the need for tighter monetary policy. In contrast, the Federal Reserve is still debating whether QE2 should be cut short. Although many members of the Federal Reserve have grown more optimistic, there are also a number of Fed officials who believe that caution is warranted.

As a result, the best that we can expect from the Fed won’t nearly be as hawkish as the least that we can expect from the ECB. The better than expected U.S. non-farm payrolls report on Friday helped to lift the dollar against the euro but we believe that the EUR/USD could make a run for fresh year to date highs ahead of the ECB’s rate announcement on Thursday. The direction of interest rates is one of the most important drivers of currencies and investors usually prefer to invest in currencies where the interest rate is high and growing and the euro certainly fits the bill. Aside from the ECB rate decision, Eurozone retail sales, German factory orders, industrial production and the trade balance are also scheduled for release. Baring any major downside surprises, the euro should be on its way to a new year to date high. After the rate decision however, the euro could weaken if a classic buy the rumor, sell the news dynamic takes hold.

This chart shows how rate hike expectations have changed in recent weeks:



In terms of how high the EUR/USD can rise, there is a VERY good chance that the currency pair will make a run for its Nov high of 1.4282. If this level is broken, then it could be clear sailing to 1.45.

 

Kathy Lien is Director of Currency Research at GFT, and runs KathyLien.com.