The prospect that European regulators could hike interest rates ahead of their U.S. counterparts is lifting the euro and could keep it on an upward trajectory temporarily, strategists say.
"That was the primary reason for the short-covering rally today," said Boris Schlossberg of GFT Forex. The euro touched 1.37 in U.S. trading before pulling back to the mid-1.36 level.
The Fed's two-day meeting, which starts Tuesday, may be a factor in how far the euro goes in its latest move.
"It has a chance to go to 1.37/1.38, but it's really going to get to if the Fed is dovish in its statement," Schlossberg said. The Fed is expected to reaffirm its plans to continue purchasing the $600 billion in Treasury securities under its quantitative program.
"Then I think the contest becomes between the relatively more hawkish ECB, and the still dovish Fed, and that could feed another spike higher."
The euro continues to defy the expectations of many analysts, who had expected to see the dollar make headway against the single European currency in the early part of the year, as U.S. economic news improved and Europe's sovereign woes dragged on.
But the betting in the euro has made an about face, illustrated by the fact that CFTC data last week showed that currency speculators turned long on the euro for the first time in two months. At the same time, they loaded up on short positions against the dollar. Net long contracts on the euro were at 4,109 contracts in the latest week, the highest level since Nov. 16. That compares with net positions of 45,192 the week earlier.
"It's a huge swing by 50,000 contracts. The data only goes up until (last) Tuesday. It doesn't get the second half of last week in. We've got to assume the market's gotten even longer euros," said Marc Chandler, chief currency strategist at Brown Brothers Harriman.
As the euro gained on the dollar during the early part of the U.S. trading day, money also rolled into some commodities and commodities-related names in the stock market, such as Alcoa , U.S. Steel and Freeport-McMoRan .
Analysts said the euro has been gaining on expectations that a plan would be in place for the ESFS European bailout fund, and the more hawkish talk from European Central Bank president Jean-Claude Trichet, who has been expressing concern about global inflation.
"In a sense, a lot of what sparked this is not certainty about where Europe's going, but uncertainty," said Chandler. "It's sort of like what happened before QE2 (the Fed's quantitative easing). We don't know what the ECB is going to do or about the ESFS. We won't know until March. The market is also pricing in very aggressive ECB rate hikes."
Analysts said the market also responded early in the day to the Medley Report, which said an ECB rate hike could come as early as third quarter. Many Fed watchers do not expect the Fed, on the other hand, to look to a rate hike until sometime in 2012.
"Now people are pricing in very aggressive ECB and Bank of England rate hikes. For the ECB, they're pricing in two rate hikes," Chandler said. Chandler, however, said he's not ready to declare a longer term trend higher for the euro, but he does think it's possible it could reach 1.38.
Brian Dolan of Forex.com said a lot of market players are focused on a level of 1.40 for the euro. He said there is key resistance at 1.3740, which is the 61.8 percent of the decline from the November highs of 142.50. "After that, we target 139.50 to 1.40 area. We'll see if this is sustained, but my bet is it's not," he said.
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