The euro bounced from a six-week low on Tuesday as markets consolidated positions after a selloff, though investors grew cautious about the single currency's outlook in the coming months on rising political uncertainty in Europe. The unexpected outcome of the German election on September 24 and Sunday's violence-marred independence referendum in the Spanish region of Catalonia has put the brakes on euro-bullish trades, with markets increasingly looking for the single currency to test the July lows of around $1.15.
"I think there's a possibility, given what's going on in Spain right now and given the fact Germany still doesn't have a government and isn't likely to get a government anytime soon, the political uncertainty is going weight on the euro," said Michael Hewson, chief market strategist at CMC Markets. A pro-independence protest in Catalonia on Tuesday kept tensions between the wealthy Spanish region and the central government in Madrid in the spotlight though Spain's bond market calmed following heavy selling the previous day. Sunday's independence vote was marred by police violence.
Still, the euro was partially supported by large option expiries on Tuesday that put a floor under the single currency. About $4 billion worth of currency options was expiring between the 1.1750 to 1.18 levels on Tuesday. The euro bounced a quarter of a percent to $1.1758 and was trading above a $1.16955, a level it last hit on August 18.
Currency markets were also looking to add bets on possible divergence between the monetary policy outlooks in the United States and Europe, with expectations growing that the European Central Bank will adopt a more cautious stance. "I don't think the market is pricing how cautious they are likely to continue to be and that will be reiterated by (European Central Bank chief) Mario Draghi on Wednesday," said Martin Arnold, a macro-strategist at ETF Securities in London who expects the euro to weaken against the dollar.
Meanwhile, the dollar climbed for a second consecutive day as a strong reading for US manufacturing activity pushed bond yields higher, prompting investors to trim some of their extreme short bets against the greenback. As anticipation of a US rate increase spread to more than 71 percent by December from 42 percent a month earlier, according to the CME's Fedwatch indicator, the dollar has rallied more than 3 percent over the last month. The dollar climbed 0.2 percent to 93.74 against a broad basket of currencies, its highest level since August 17. Despite its recent gains, the dollar is down more than 8 percent this year, on track for its biggest annual decline in a decade.
The dollar's surge put the pressure on carry trade currency favourites such as the Aussie and the New Zealand dollar , which were down by more than 0.3 percent each. The Australian dollar fell to its lowest in more than two months after the Reserve Bank of Australia left interest rates unchanged and gave a cautious assessment of the local economy.
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