Why did the euro pop and drop after Greece deal?

The euro fell sharply after staging a mini rally on Monday despite Greece reaching a deal over its third bailout, as investors turn their attention to the timing of a U.S. interest rate hike.

The volatility, which sent the single currency hitting $1.1196 against the dollar before dropping more than 1 percent to hit hit lows of around $1.10400. The euro was also down over 1 percent against sterling at £0.7106.

Analysts said that the brief pop and drop seen by the euro can be explained by the safe haven status that the currency took on during the Greek crisis. It has remained fairly stable as negotiations between the debt-stricken nation and its creditors dragged on.

"For the last 12 months, the euro has been a funding currency of choice, as the ECB has pledged low interest rates for the long-term and embarked on QE (quantitative easing)," Kathleen Brooks, U.K. and EMEA research director at FOREX.com, said in a note.

"Now that the uncertainty around Greece has been, hopefully, eradicated, the market may choose to return to higher risk FX strategies like the carry trade, which could put further downward pressure on the single currency."

An image of Euro banknotes being counted. The central bank policies have hit bank profitability in both regions and German banks have been vocal in criticizing Mario Draghi, ECB president, accusing him of punishing savers and undermining their business models.
Leonhard Foeger | Reuters
An image of Euro banknotes being counted. The central bank policies have hit bank profitability in both regions and German banks have been vocal in criticizing Mario Draghi, ECB president, accusing him of punishing savers and undermining their business models.

A funding currency typically has a low interest rate. Investors borrow it in order to take a position in another currency with a higher interest rate – a strategy known as a carry trade.

Euro trading like yen

The ECB's asset purchase program has made the euro attractive as a funding currency. Now that investors feel that the worst of the Greek crisis is behind, analysts note that there will be more risk-taking, pushing the euro lower.

"When sentiment improves, the euro weakens as appetite for risk increases and euro trades like Japanese yen," Piotr Matys, emerging market FX strategist at Rabobank, told CNBC by phone.

He added that the yen – a typical funding currency – was also traded lower against the dollar after the Greek negotiations ended, confirming the view that the euro had taken on this status.

At the same time analysts also note that there is still the risk of future uncertainty over Greece, which could have kept a euro rally at bay.

"Today's deal does kick the underlying issues further into the future and at some point, they will have to be addressed," Simon Smith, chief economist at FX pro, wrote in a note.

"The primary one is the sustainability of Greek debt. The wider one is that of operating a single currency with no real degree of fiscal coordination."

Dollar 'clear winner'

The dollar was over 1 percent higher against the Swiss franc and trading 0.5 percent higher against the yen, as investors began to focus on the first Federal Reserve interest rate hike in the U.S.

U.S Federal Reserve chair Janet Yellen said in a speech last week that a rate rise would be "appropriate at some point later this year". Boston Fed President Eric Rosengren, told Reuters that a rate hike could come as early as September.

With instability surrounding Greece now on the back burner, analyst said the Fed's movements are in investors' crosshairs.

"The one clear winner from tonight's events was the dollar. With Grexit now off the table, the Fed will not have to worry about systemic risk and may focus seriously on rate normalization with September hike possibly back on the schedule," Boris Schlossberg, managing director of FX strategy at BK Asset Management, said in a note.