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The Euro is still trading above 1.35 against the US dollar but fell slightly today as political tensions in Italy escalated over the weekend and the US dollar weakened as a deadline to avert a government shutdown in Washington is approaching with the deadline midnight Eastern time..

The Euro has been weighed down by an increasingly volatile Italian political crisis after Silvio Berlusconi pulled his ministers out of the government on Saturday and called for new elections. This has ensured a detrimental impact on the strong Euro today. However, with the US government shutdown causing the US dollar to weaken, Sterling seen over valued, the Swiss Franc and the Yen have been beneficiaries as their relatively strong governments have encouraged a flow of capital into those currencies.

A US government shutdown would increase the chances of no tapering in October and perhaps no tapering until the end of the year which would weaken the US dollar and other majors would be major beneficiaries. Obama’s dithering over the selection of the next Federal Reserve chairperson as well as the indecisiveness over Syria has put into question his leadership qualities and a flow of capital out of the US.

The Euro has remained in a narrow range of 1.28-1.36 range all year, which is on track to be the tightest range since the inception of the Euro on 1st January 1999. There are a few reasons why the Euro may at last start to decline after the tremendous recent run:

There are concerns about who will form the coalition government in Germany where there are growing signs of discontent with regards to the Euro as the recent elections demonstrate that the anti-Euro party – Alternative for Germany (AFD) getting 4.7 per cent of the vote in the election which is an astonishing success for a party only seven months old. The elections in Austria over the weekend have also shown that there is much anti-Euro sentiment with the anti-euro, anti-immigrant Freedom Party (FPO) scoring its best result ever, with 21.4 per cent of the vote. This clearly shows how strong the anti-Euro movement is currently but is not yet shown in the markets.

The 2 year rate differentials, which have been a key driver of the Euro could finally start to move meaningfully in favour of the dollar. This could come about when the Fed finally starts tapering and so the market then focuses on the policy rate path which will push the Euro substantially lower.

The sharp rise in foreign buying over the last few months of euro equities is very unlikely to be sustained. As well as it being the largest in history relative to foreign buying of US equities, there has never been such a divergence between foreign buying and the trend in relative valuations. Business media channels have been harping on about the growth potential of European equities and how bullish analysts are of the European markets but with a strong Euro many global export companies are hurting as the strong Euro has a massive detrimental impact on overseas profits. This is probably a sign that the best of the rally is over and and caution should be the watchword now as over confidence is a sure sign that a fall is inevitable. European equities have become more expensive and valuations are certainly not as enticing as they were earlier in the year. Unemployment is still a major concern for much of Europe and until that situation reverses strongly there will be always be concerns about the Eurozone economy.

Take the current strength in the Euro with a pinch of salt and expect a sharp reversal over the final months of the year.

Further reading: Euro to USD forecast.