Yesterday, EURUSD fell to a 17-month low. The pair has managed to stage a bit of a recovery. However, this might just be a bounceback ahead of further downside. The recent weakness in the euro threatens to reverse last year’s gains in the currency pair. This implies substantial downside potential.
The low reached after the stronger-than-expected US CPI figures hit both a fundamental and a technical level. Last year, the euro rocketed higher after US President Donald Trump started his tariff wars. It gained as much as 17% on the dollar. Recent developments suggest a reversal of the flows that drove the euro higher in the first place. The pair will likely need substantial support to return to pre-September levels.
Why the Currency Pair Could Reverse
Last year, traders sold the dollar heavily and primarily bought the euro. They expected Trump’s trade war, policy uncertainty and high US deficits to compare unfavourably with Europe’s more stable fiscal and trade policy. Europe announced large spending programs in infrastructure and defence. Meanwhile, markets expected a Republican Congress and White House to cut spending. Markets widely viewed Fed policy as restrictive. The ECB could keep rates at half the Fed’s as inflation remained on target.
Since then, particularly going into last summer amid the unresolved war in the Middle East, the situation has reversed. The promised fiscal spending in Europe has been slow to materialise. Higher energy prices have pushed up inflation, forcing the ECB to raise rates. Meanwhile, the shared economy has sputtered along. Political uncertainty in Europe has reasserted itself. Traders are increasingly concerned about France’s inability to rein in its deficit and the AfD’s gains in German elections.
Last year’s reasons for investors to sell dollars and buy euros have largely vanished. The situation is also starting to turn around. The US economy remains resilient despite the uncertainty, and US yields offer an attractive bonus.
The Fed and ECB Diverge
Europe’s central bank tackled rising energy prices aggressively, hiking through the summer. But now it has turned more dovish. The market now expects the ECB to “skip” a rate hike at the next meeting. This follows comments from several members of its policy-setting committee suggesting that inflation remains contained.
Lagarde spoke on Wednesday and hit the same notes as prior speeches. She also said that the ECB was unlikely to intervene in the French fiscal situation. Markets took this as a dovish sign. The central bank will announce its policy decision on October 29. No major data releases are due in the interim, allowing the market to lock in its expectations.
What to Watch in Warsh’s Speech
Next up is Fed Chair Kevin Warsh, who will speak at the IMF Symposium in Bangkok, Thailand. Expectations for his speech are high, as markets expect him to address monetary policy. It is also his last intervention before the blackout period preceding the October 28 rate decision. The hot US CPI figures pushed expectations for a hike at the next meeting to over 70%.
Markets expect Warsh to stick to his style of not providing traditional forward guidance. However, traders will watch closely to see whether he maintains his inflation-first rhetoric. If that’s the case, the market could fully price in a rate hike. This could boost the dollar and drag EURUSD lower.
On the other hand, he might mention the weak September jobs data. The market could then pull back expectations for a rate hike, helping put a floor under EURUSD.
