What do the latest Fed, ECB decisions tell about the direction of the EUR/USD?
The Federal Reserve (Fed) expectations soften as Jerome Powell says the ‘disinflationary process is now underway’, while the European Central Bank (ECB) expectations remain hawkish although Christine Lagarde revised the eurozone’s inflation outlook to ‘balanced’ in her latest press conference.
In this article, we discuss whether the latest developments in policy decisions are supportive of a further EURUSD rally, what are the key technical levels that investors should watch, and what are the risks to the bullish euro outlook.
The Federal Reserve (Fed) raised its interest rates by 25 basis points on February 1, and threw the foundation of a policy pivot in the foreseeable future.
‘It is gratifying to see the disinflationary process now getting underway’ said the Fed Chair Jerome Powell at the press conference that followed the latest FOMC decision.
Yet, Powell highlighted that inflation ‘has eased but remains elevated’ and concluded that the Fed’s job of bringing inflation on a solid path to 2% policy goal is NOT done. There are more interest rate hikes on the pipeline, he said.
In vain, risk assets rallied, the US yields and the US dollar tanked, and money markets went to price in a 50 basis point rate cut by the Fed before the end of the year.
Have investors misunderstood Powell?
Probably, YES. Jerome Powell did look ‘gratified’ faced with easing price inflation in the US.
The US CPI eased from 9.1% peak released in summer to 6.5% at the end of the year. US core inflation fell from 6.6% to 5.7% between October and December.
This is encouraging for the Fed’s fight against inflation.
However, easing inflation is only a part of the story.
The US jobs market remains very tight by historical means. The job openings remain at historically high levels and wages growth remains robust. The latter factors make US price inflation vulnerable to sudden jumps, and the Fed vulnerable to a premature pause in its rate tightening policy.
Add to that the Chinese reopening — that will certainly apply a positive pressure on global energy and commodity prices — and you are left with nothing but a blurry path for inflation in 2023.
This is why the Fed warned that there will be more rate hikes on the pipeline before a pause to the actual policy tightening cycle.
‘The committee anticipates that ongoing increases in the target range will be appropriate in order to attain a stance of monetary policy that is sufficiently restrictive to return inflation to 2% over time’.
This is what the Fed said.
‘The Fed will stop hiking the rates soon and will cut the interest rates before the year end’ is what the markets heard.
Activity on Fed funds futures gave around 83% chance for another 25bp hike at the wake of the FOMC meeting.
This means that the interest rates will likely hit the 5% mark, as promised by the Fed members.
But this also means that the Fed sees light at the end of the tightening tunnel.
Unlike the European Central Bank (ECB).
ECB hiked by 50bp, hinted at another 50bp at next meeting.
Across the Atlantic Ocean, less than 24 hours after the Fed’s 25bp rate hike, the ECB announced to raise its interest rates by 50bp in February, and hinted that there will be another 50bp hike at the March meeting.
The ECB will also start unwinding its balance sheet starting from March.
However, the latest 50bp hike from the ECB sounded more dovish than the one announced in December, when the ECB Chief Christine Lagarde promised a series of 50bp hikes.
At that time, it sounded like the ECB would raise the rates by 50bp beyond March.
Right now, it feels like the ECB could slow down the pace of interest rate hikes depending on the data.
And given that inflation in the Eurozone recently fell to 8.5% in January, below 9% expected by analysts, the data-dependence may be interpreted as a dovish shift in the ECB’s monetary policy stance.
Madame Lagarde, however, remains concerned by the upside pressure on wages, hopeful on downside pressure on energy prices, but mostly uncertain about what the future holds.
What is certain, however, is that there is no sign of a pause to the ECB rate hikes at this stage.
Where is the EURUSD headed?
The fact that the Fed is approaching the end of its actual rate hiking cycle is negative for the US dollar.
More so, as the US dollar index rallied up to 28% between May 2021 and September 2022 as the Fed tightened its monetary policy remankably more than initial expectations.
During most of this period, the ECB remained quiet, kept its interest rates below zero and hoped that inflation would go away by itself.
But it didn’t.
Finally, the ECB acknowledged Europe’s worsening inflation problem, but the late ECB reaction to rising inflation sent the euro below parity against the US dollar in September 2022.
At its worst, the euro lost more than 22% against the greenback between January 2021 and September 2022.
Since then, the ECB’s stance dramatically changed. In fact, the ECB went from conducting one of the most dovish monetary policies in the complex of G10 central banks to one of the most hawkish monetary policies.
The EURUSD rebounded more than 15% since the September dip on the back of softening Fed expectations and the strengthening ECB bets.
The outlook in EURUSD remains positive on expectation that the ECB will keep raising the interest rates, while the Fed will stop, and eventually cut rates.
The Tecnical Perspective
From a technical perspective, the EUR/USD has stepped into the bullish consolidation zone around mid-December after clearing the major 38.2% Fibonacci retracement on 2021–2022 selloff, at 1.0618.
The EURUSD will remain in the bullish consolidation zone above this level, and price pullbacks could be interesting dip-buying opportunities for further medium-term appreciation in the single currency.
The next natural target for euro bulls stands at 1.1220/1.1225, the 200-week moving average.
The EUR/USD could extend gains to the 1.15/1.17 range in the continuation of the actual positive trend, as the Europeans, and the euro have more catch-up to do with their American peers in terms of monetary policy tightening, and currency valuation.
The major risks to the euro’s strength are the slowing economic activity in the Eurozone and a potential re-escalation of the energy shortage fears and recession odds — which would force the ECB to consider a softer monetary policy, and eventually a premature pause to its policy tightening.
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