EUR/USD At 5-Week High; U.S. Fiscal Cliff Given 'Benefit Of The Doubt'

Includes: FXE, UDN, UUP
by: FXstreet

Hopes, hopes and more hopes, that seems to be the central theme enhancing the EUR/USD allure in recent days, while making other risk assets an attractive bet - for the time being - as we enter a new month of trading.

Despite the market is still caught in a cross-fire of words from both US Republicans and Democrats to reach a fiscal compromise, price action suggests investors remain buying and pricing in a possible 11th hour deal. Such optimism has taken the EUR/USD to trade firm above the 1.30, having touched a new 5-week high in Asia.

According to Kathy Lien, Co-Founder at BK Asset Management, "we continue to believe that Congress will announce a partial deal at the eleventh hour that involves closing loopholes, limiting deductions and extending Bush era tax cuts for low to middle income households. Congress is not unfamiliar with 11th hour deals, and given the significance of the Fiscal Cliff, severity of the consequences and the fact that up until now, Republicans and Democrats remain miles apart, an 11th hour announcement of a partial deal days and possibly even hours before Christmas is still a likely scenario."

While Kathy's prediction is likely to come true, and we will see a deal before December 31st inked, the key question mark now is how much leeway in risk appetite is left before a transition occurs, and more conservative bets enter the market. As far as price goes, patience for a positive outcome seems ample and regardless of the little progress on US fiscal negotiations so far, there are no indications that a turn in sentiment is due. Markets have given 'the benefit of the doubt' for now.

EU bond yields playing an important role on Euro strength

Other than attributing the recent Euro strength to the market's optimism that a deal to avoid the fiscal cliff can be sealed, the significant decline in European bond yields - Spanish 10 year yields below the 5.5% mark - and the absence of an immediate risk of Greece defaulting after Germany's Bundestag approved the Greek bailout deal, are all factors encouraging the bid tone.

Can Spanish bonds continue to keep up its striking performance? Since price movements act as a discounting mechanism on future outcomes, what the bond market is telling us appears to be that either Spain can start putting its house in order - don't be fooled by such assumption - or simply that as 2013 approaches and more funding is needed for Spain, they will have to, at last, bite the bullet and make an official bailout request.

The controversy here is that since yields in Spain's 10-year bonds are now closer to 5% than 6%, the government will likely still find its financing ordeal affordable to discard a bailout. If we add Spanish Prime Minister Rajoy's latest comments over the weekend, saying it will be hard to meet the country's deficit target, we seem to have a divergence on what the market is really pricing into the Spanish bonds and reality, as neither an immediate bailout nor an improvement of the economy looms near. Lower bond yields in the Eurozone, a contributing factor in Euro strength, may therefore have its days numbered.

Meanwhile, Greece is set to unveil details of a debt buy-back today. The new conditions should meet enough interest among Greek bondholders to cut Greek debt by an agreed 20 billion euros. The ultra-indebted nation intends to spend to the tune of 10 billion euros from its bailout deal to own over 30 billion euros worth of bonds in exchange. The buybacks need to be finalized by December 13 if Athens is to receive 30 billion euros of bailout money. The IMF has insisted that a debt buyback must be complete in order to participate in its share of the bailout disbursement., BBH, optimistic on EUR/USD

Technically, the break above 1.3030, which follows a promising sequence of daily higher highs and lows, has in-house technical strategist Valeria Bednarik forecasting, "the pair will be able to extend its gains further this Monday." The downside, as long as limited by 1.2940/70 area, will not alter the bullish picture, the analyst says.

According to Marc Chandler, Global Head of Currency Strategy at BBH, EUR/USD should continue trading higher for a move towards $1.3140 target. "A break of $1.2935-50 would call the constructive view into question," he adds.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.