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Euro Rally Ripe for Reversal

NEW YORK ( TheStreet) --The euro is continuing its latest bull run higher, gaining against most of its major counterparts and hitting levels against the U.S. dollar that have not been seen since the middle of June.

The rally in the euro has been propelled by comments from the German Bundesbank, suggesting that policymakers in the eurozone are not predisposed to maintaining interest rates at their historical lows and that rates could rise, if upside pressure is seen in consumer price levels. Those statements jarred some sections of the market, as this marks a direct contradiction to previous comments made by European Central Bank President Mario Draghi, which signaled a prolonged intention to keep monetary policy accommodative as a way to boost the struggling eurozone economy.

[Read: <a target="blank" data-add-tracking="true" href=""><em>European Assets Reap Benefit of Weaker Markets Elsewhere</em></a>]

Rallies in the euro have been broad based, with valuations in the EUR/JPY rising above the 131 level, as well. But the next question going forward is whether this rally is sustainable, given the rising Treasury yields seen in the U.S., little evidence of progress in the eurozone's elevated unemployment rate, and the growing likelihood that the Federal Reserve will begin to enact policy changes that will strengthen the U.S. dollar.

Given this set of event risks, the CurrencyShares Euro Trust ETF (FXE) starts to look much more like a "sell," at current levels, with recent weakness in the PowerShares DB US Dollar Index Bullish ETF (UUP) looking attractive as a buying opportunity.

Rate Outlook in U.S., Eurozone

The prospect of rising interest rates could be bullish for the euro, as increased yields make currency positions more attractive. But with yields in the bellwether 10-year Treasury note hitting two-year highs of 2.9%, it is clear that the market is pricing in an increased chance the Fed will start to roll back its programs in quantitative easing.

The latest analyst surveys show a majority expecting the Fed will cut its monthly asset purchases by $10 billion, and the next indication of whether these projections are accurate will come on Wednesday. This is when the minutes from the July FOMC meeting are scheduled for release.

The report will offer key clues about the Fed's position on the strength of the economy. An upbeat assessment will lead to renewed speculation that the U.S. is positioned strongly enough to begin making reductions to monetary stimulus. If we do, in fact, see September tapering, expect to see a massive surge in the U.S. dollar -- especially against the euro, given the relative weakness we have seen in the last two months.
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