Euro faces headwinds as contagion risk intensifies

Talking Points

· Japanese Yen: Higher Against Most Majors

· British Pound: Stands Ready To Aid Ireland

· Euro: Risks For Contagion Gathers Pace

· U.S. Dollar: Chicago Fed Index on Tap

The Euro fell back from a high of 1.3785 during the overnight trade as Ireland opted to seek a bailout from the EU, and the single-currency may face increased headwinds going into the North American trade as the risks for contagion intensify. In response to the bailout, Moody’s Investor Services said that Ireland is likely to face a “multi-notch” downgrade, while European policy makers argued that it’s still premature to speculate on the size of the rescue package. In an effort to stem the risks for contagion, the EU announced that Portugal’s banking system is healthy and resilient, but went onto say that the euro-area continues to face an uneven recovery as the governments operating under the fixed-exchange rate system struggle to manage their public finances.

At the same time, European Union Economic and Monetary Commissioner Olli Rehn said that the issues Portugal faces are “very different” than Ireland’s as the country “has taken very bold decisions concerning fiscal consolidation and continuing its structural reforms,” but the risks for contagion could lead the European Central Bank to support the economy going into 2011 as it aims to balance the risks for the region. As fears surrounding the debt crisis exacerbates, the ECB may put its primary mandate on the line as it aims to restore financial stability, and speculation surrounding the outlook for monetary policy could play an increased role in driving price action for the euro as the central bank talks of reestablishing its exit strategy in the coming months. As the EUR/USD continues to hold below the 20-Day SMA at 1.3810, the euro-dollar may pare the rebound from the 50.0% Fibonacci retracement from the 2009 high to the 2010 low around 1.3490-1.3500, which could lead to a test of the August high (1.3333) in the coming days.

The British pound pared the overnight rally to 1.6083 as the U.K. pledged to assist Ireland, and fears surrounding the European debt crisis could drag on the exchange rate as Britain struggles to manage its own public finances. U.K. Chancellor of the Exchequer George Osborne said that he stands ready to help the “friend in need” while speaking on the BBC radio, and went onto say that the U.K. has made “a commitment for a bilateral loan” in an effort to ease the turmoil in the European financial system. As the U.K. aims to curb its budget deficit and tightens fiscal policy, there could be increased pressures on the Bank of England to support the economy in 2011, but the stickiness in price growth could spur an increased split within the MPC as policy makers expect inflation to hold above target throughout the following year. As the economic outlook remains clouded with uncertainties, the GBP/USD may work its way back towards the 50-Day SMA (1.5874) to test for near-term support, but we should see the exchange rate push higher throughout the remainder of the year as it maintains the upward trend from May.

U.S. dollar price action was mixed overnight, with the USD/JPY bouncing back to reach a high of 83.56 on Monday, and we may see a clear trend develop during the North American trade as equity futures point to a lower open for the U.S. market. As the economic docket remains fairly light for Monday, risk sentiment is likely to dictate price action in the currency market, and we may see little reaction to the Chicago Fed’s National Activity index, which is expected to increase to -0.24 in October from -0.58 in the previous month, as speculation surrounding Ireland’s bailout takes center stage.

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