EUR/USD on the Offensive, but Road Ahead Remains Tough

Euro Fundamental Forecast: Neutral

• Euro gained last week, but this seemed as a result of US Dollar losses
• Traders may have overcooked hawkish Fed hawkish policy estimates
• Monetary policy divergence likely to make road ahead tough for EUR

Last Week’s Recap

The Euro turned a corner this past week, with it breaking out of persistent consolidation against the US Dollar. This pushed the single currency to its highest point since the middle of November. Gains weren’t spread out evenly, however. The bulk of its appreciation was seen in EUR/USD. Pairs like EUR/JPY, EUR/GBP and EUR/AUD were relatively mute.

This could be a sign that the single currency was a benefactor of broad US Dollar depreciation, rather than strength in its own merits. In fact, the DXY US Dollar Currency Index sank to early November lows. With that in mind, the focus for the Euro could remain glued on external factors. However, there are a few regional economic events to keep an eye out for.

Euro Week Ahead

Looking at the hourly chart below, I have overlaid a majors-based Euro index with an equivalent US Dollar one on the upper portion. On the lower half is the spread of German and US 2-year government bond yields. As you can see, since the beginning of this year, front-end Treasury rates have been clearly outperforming their German equivalents.

This can at times be a recipe for EUR/USD weakness, but this has not been the case as of late. In fact, the US Dollar has been decoupling front local bond yields recently. This could perhaps be due to traders already front-running Federal Reserve rate hike bets. In fact, the US Dollar broadly declined on a mostly in-line local inflation report, showing CPI at a 40-year high.

Still, the road ahead for the Euro is challenging. Overnight index swaps are only pricing in one 10-bps rate hike from the European Central Bank in 2022. This is as opposed to over 75-bps of tightening from the US, plus potential balance sheet unwinding. It thus seems more likely that the Euro could benefit more from the markets overestimating a hawkish Fed, as opposed to a more aggressive ECB.

The week ahead brings the ECB’s account of the December policy meeting. The document could reiterate the central bank’s patience. President Christine Lagarde noted in December that they are ‘very unlikely’ to raise rates this year. Fading Euro-Area industrial production data amid Omicron-induced regional restrictions may underscore this.

Euro, US Dollar, German – US Government Bond Yield Spreads – Hourly Chart

Chart Created in TradingView

— Written by Daniel Dubrovsky, Strategist for DailyFX.com

To contact Daniel, use the comments section below or @ddubrovskyFX on Twitter