EUR/USD: dollar leads the euro by the nose, threatening to derail it

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 On Friday, the main currency pair took a pause in the rally, as a result of which it reached two-week highs a day earlier. On Thursday, the euro was supported by the minutes from the European Central Bank's April meeting. The central bank stressed that high inflation is likely to persist for some time, and confirmed that an increase in the discount rate some time after the end of the asset repurchase program may mean as little as one week. Ahead of the weekend, the euro is consolidating yesterday's growth, and the greenback is trying to shrug off its recent losses. The USD index is currently trading in positive territory around 103.00 points, but remains about 1.5% below the levels of the beginning of the week. The US currency is close to breaking a six-week winning streak. It fell with the key Wall Street indices on Thursday. The S&P 500 sank by 0.58% to 3900.79 points. The indicator has fallen by about 19% since its January peak, coming close to the bearish trend. The S&P 500 is down more than 3% this week and is preparing to close in negative territory for the seventh consecutive week. The USD index registered the biggest intraday drop since the beginning of March, losing more than 1% on Thursday. A sharp decline in US Treasury bond yields has reduced demand for the dollar, despite the flight from risk. The day before, the yield of 10-year treasuries sank to the lowest level in almost a month at 2.77%. Protective bonds have increased in price, and their profitability has decreased accordingly, as investors have reduced investments in securities.Apparently, market participants are questioning the Federal Reserve's ability to implement a "soft landing" of the economy, which the central bank is counting on following the results of the next cycle of rate hikes.


Most analysts polled recently by Reuters believe that the federal funds rate will be at 2.50%-2.75% by the end of 2022. This exceeds the "neutral" level, which does not stimulate or restrict economic activity (approximately 2.4%). Experts on average estimated the chances of a recession in the United States over the next two years at 40%. At the same time, the probability that this will happen next year is one in four. "As soon as the Fed starts raising rates, they keep raising rates until something breaks. Now the question arises: what should we look at as a potential breakthrough? The stock market? Lending? Housing? I think it will be a big unknown in this cycle," said strategists at BMO Capital Markets. The United States published data that showed that the number of Americans who applied for unemployment benefits for the first time increased by 21,000 last week, to 218,000 people. Meanwhile, the number of home purchase and sale transactions in the US secondary market in April decreased by 2.4% compared to March, to 5.61 million. Another report reflected a drop in the Philadelphia Federal Reserve's index of manufacturing activity in May from 17.6 to 2.6 points. These data increased worries about a potential recession and added to the worries of investors, who continued to sell stocks on Thursday.Weak quarterly reports of major American retailers added fuel to the fire, which pointed to the negative impact of increased inflation. To be sure, consumers continue to spend, but many of the leading U.S. retailers cannot cope with higher labor costs and higher prices caused by continued supply chain constraints.


China's exit from quarantine due to the coronavirus remains unclear, which threatens to increase global price pressure, even though Shanghai is preparing to allow more businesses in areas with zero COVID levels to resume normal operations from the beginning of June. The increase in the number of new cases in Beijing and Tianjin indicates a high risk of new social restrictions in these cities. In particular, the lockdown in Tianjin, a major port city, is the main risk for the markets. In this case, it will be possible to expect increased interruptions in the supply of goods from China. This will have negative consequences for inflation in importing countries. The military conflict in Ukraine also shows no signs of abating, clouding the prospects for inflation driven by commodity prices. Against this background, fears are growing that the Fed will have to be even more aggressive in terms of tightening policy, which, as a result, will damage the economy. These concerns resulted in a rout in the US stock market on Wednesday, when the main Wall Street indexes fell by 4% or more. On Thursday, they remained under downward pressure amid the impending economic downturn. The Fed is not targeting stock markets in its fight against inflation, but this is one of the ways where the impact of tightening monetary policy will be felt, Kansas City Fed President Esther George said. A sell-off in stock markets may eventually prove as important as raising interest rates to curb demand, according to Citi economists.According to them, raising interest rates by itself may not be enough, for example, to cool the housing market.


"Part of the work related to the tightening of financial conditions will be related to the current decline in stock prices by about 18%. If the goal is to reduce the number of vacancies, it is easier to see the relationship between stock prices, corporate sentiment and hiring plans than between interest rates and vacancies," Citi said. Scott Minerd of Guggenheim Partners believes that the decline in US stock indices observed in recent days may be just the beginning of a large-scale collapse that will reach its peak next summer. In his opinion, there is a possibility that the S&P 500 index will fall by 45% from its January peak. "It's a lot like the collapse of the dot-com bubble," he said. The Fed has sent a clear signal that it does not intend to stop raising the rate, despite the risks to stock markets. In other words, the central bank will tighten monetary policy until they see a clear break in the inflationary trend, even if the indices fall, the expert believes. A similar point of view is held by Jeremy Grantham from GMO. "The stock market is a bubble similar to the bubble of 2000, which is in the process of deflating," he said. Grantham expects the S&P 500 to fall at least 40% from its peak. This will cause the index to reach approximately 2880, a level not seen since March 2020, caused by a bear market due to COVID-19. It is possible that at some stage the Fed will soften the rhetoric, which will signal a reversal of stocks, especially if inflationary pressures caused by high commodity prices and the impact of the pandemic on labor and materials supplies reverse. Investors may have to be patient for a few months. So far, the US central bank is determined and intends to restrain prices by cooling the economy.


This week, Fed Chairman Jerome Powell said that the central bank will raise interest rates as high as necessary, possibly even above the neutral level, to suppress price pressure. It is noteworthy that the greenback is reacting less and less to the hawkish signals from the Fed. The greenback has already retreated by almost 2% from the 20-year highs recorded a week ago in the area of 105. Such dynamics reflect investors' fluctuations regarding the prospects of the US economy, around which the risks of recession are increasing.An important role is played by the fact that other leading central banks are also tightening their rhetoric, reducing the gap between their policies and the mood of the Fed. On Tuesday, ECB spokesman Klaas Knot said that a 50 basis point rate hike in July is possible if inflation increases. Commerzbank analysts note that Knot is the most ardent hawk and his position does not necessarily reflect the opinion of the majority in the ECB Governing Council. "Nevertheless, by making this comment, Knot opens a new line of attack for the ECB hawks," they said. Some experts believe that a sharp increase in the Fed's interest rate and quantitative tightening over the next two years have already been factored into the value of the dollar. According to the calculations of Goldman Sachs strategists, the US currency is now overvalued by about 18%. Deutsche Bank analysts, in turn, point out that the US dollar is currently the most expensive currency in the world. "The dollar exchange rate is too high. Our forecasts suggest that in the coming months the EUR/USD pair will return to 1.1000, and not to parity," they said. However, there are those who are more positive about the US currency. They believe that the euro will eventually weaken even more against the dollar. "The USD index may adjust slightly lower to 102.30, but we see this simply as a consolidation of the bull market, and not as the formation of a peak," ING analysts said. "As long as the Fed does not cool the expectations of the markets regarding the tightening of its policy, the dollar will not reach peak highs," they added. According to experts, it will be possible to talk about breaking the short-term upward trend only when the USD index falls below 102.30, where the lows of May are and the Fibonacci correction level is 61.8% relative to the last bullish move since the beginning of April. As for the EUR/USD pair, as noted in ING, it may return to the area of 1.0650-1.6070 in the coming days. "This will be facilitated by short periods of calm in the external environment, but we will regard this as a rebound of the bear market. Our main forecast for EUR/USD for the second half of the year is increased volatility and a likely approach to the parity level in the third quarter of 2022, when expectations for the Fed tightening cycle may be at their peak," the bank's strategists said.


Currently, money markets are putting in quotes an increase in rates in the eurozone by more than 100 bps this year. The ECB should soon begin to actively catch up with these expectations, otherwise the euro will lose a serious support factor. Despite the recent hawkish shift in policy, the ECB is still falling behind its US counterpart, which is expected to raise the key rate by 350 points until March 2023. The prospect of a significant divergence in monetary policy between the Fed and the ECB may have a negative impact on EUR/USD, analysts at BMO Capital Markets believe. According to them, the political inertia of the ECB during the summer may lead to parity between the euro and the dollar in the form of keeping the key rate unchanged, as well as a complete German embargo on imports of Russian fossil fuels, which will lead to rationing of energy in the country. "It is not surprising that the ECB's political inertia will continue if the central bank is faced with the worst possible combination – an increased risk of recession in Germany and an additional sharp rise in prices (that is, terrible stagnation)," BMO Capital Markets said. Meanwhile, Credit Suisse still believes that the main currency pair is forming a short-term basis, and a break of 1.0642 will be a confirmation. "Short-term resistance is observed at the level of an accelerated downtrend at 1.0608 before the 23.6% Fibonacci retracement of the fall from the February and May highs at 1.0620–1.0642. A breakdown of this area will confirm that the short-term base has been formed to provide a platform for a deeper recovery to the 38.2% Fibonacci retracement, the 55-day moving average and the mid-April lows at 1.0758–1.0794. This barrier should be much tougher," the bank's analysts noted. "Initially, support is expected at 1.0508, and the 1.0465-1.0460 area needs to be maintained in order to maintain an immediate upward slope. A breakdown of this area may clear the way for a repeat test of 1.0350-1.0341," they added.



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