Euro / Dollar Week Ahead Forecast: Yield Handicap Weighs as Fed Looms

• EUR/USD subdued after recovery effort stifled
• ECB-Fed divergence cementing yield handicap
• Yields, Fed policy & market volatility help USD
• ECB’s slower inflation response weighs on EUR
• EUR eyes PMIs as USD awaits key Fed decision

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The Euro to Dollar rate’s early January recovery was stifled last week when global market volatility and a sell-off in U.S. bonds burnished a yield advantage that could keep the greenback supported and the Euro subdued as market attention fixes on the Federal Reserve (Fed) this week.

Dollars were bought widely last week as the U.S. currency appeared to draw a line under a new year sell-off that had enabled the Euro to climb back toward the 1.15 handle during the early days of January, with the greenback’s rally coming amid heightened volatility in global stock markets.

While Chicago Futures Trading Commission data suggested last week that investors significantly reduced bets on the Dollar during the prior period, global market volatility has revived appetite for a greenback that could benefit again over the coming days from a market focus on Fed policy.

"EURUSD has maintained the weak tone following its bearish “reversal day” and the market is not only back below the “neckline” to its near -term base at 1.1387, but also below its 13 - and 55 -day moving averages,” says David Sneddon, head of technical analysis trading strategy at Credit Suisse.

“This should add weight to our base case that the consolidation from last November and recent strength remains a corrective phase only ahead of the core downtrend eventually resuming. Support is seen at 1.1313 initially and then more importantly at the recent reaction lows and uptrend from November at 1.1285/72,” Sneddon and colleagues wrote in a review of the Euro-Dollar rate’s charts last week.

Above: EUR/USD shown at daily intervals with spread, or gap between 02-year German and U.S. government bond yields.

• EUR/USD reference rates at publication:
  Spot: 1.1319
• High street bank rates (indicative band): 1.0923-1.1000
• Payment specialist rates (indicative band): 1.1217-1.1262
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Forthcoming corporate earnings reports could prolong the recent international market volatility, which would be favourable for the greenback and a headwind for the Euro.

The bulk of attention will however be on Wednesday’s Fed decision, which is the highlight of the week and the bank’s first opportunity to address December’s acceleration of U.S. inflation to a fresh multi-decade high of 7%.

“Earlier this month, there was a shake-out in long USD positions, though this proved short-lived with USD bulls unable to resist the draw of another move higher in US bond yields. We remain constructive on the outlook for the USD,” says Jane Foley, head of FX strategy at Rabobank.

“Aside from supportive interest rate differentials, the USD may be a beneficiary of safe-haven flows in the weeks ahead connected to the news-flow regarding a possible Russian invasion of Ukraine,” Foley wrote in a review of the Euro-Dollar rate’s outlook last week.

The Fed already accelerated the winding down of a once $120BN per month quantitative easing programme in December and indicated strongly that an initial increase in the Fed Funds interest rate could be announced as soon as March.

The market is however likely to listen closely on Wednesday to hear whether the bank’s views of the inflation and interest rate outlook have shifted further in the ‘hawkish’ direction since December’s inflation data.

Above: EUR/USD at daily intervals with Fibonacci retracements of November recovery attempt indicating likely technical support for Euro.

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“While the ECB is ready to act by removing accommodation if inflation proves more persistent, it has expressed equal concern about scaling back stimulus prematurely. With sentiment indicators unlikely to show much upward momentum in the short term due to still disruptive COVID-19-related restrictions, our EURUSD 1.12 forecast for March may soon be reached,” Gaétan Peroux, CFA and FX strategist at UBS Global Wealth Management.

Although the Fed has been a significant driver of the widening gap between U.S. and European bond yields, which has benefited the Dollar, the Euro has also been weighed down by a slower and lesser overall response by the European Central Bank (ECB) to recent increases in inflation, which is born out of scepticism of the idea that these price increases will last.

President Christine Lagarde reiterated last Thursday in an interview with France Inter radio station that Europe’s economies are expected to escape the prolonged inflation that could be seen in the U.S. and elsewhere over coming quarters, which is why ECB has been that its interest rate is highly unlikely to rise before 2024, if not after.

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This is one reason why economic numbers like Monday’s IHS Markit PMI surveys, which are the highlight of Eurozone economic calendar this week, tend to have a lesser impact on the Euro to Dollar rate than equivalent figures do with other currencies and could easily go overlooked this week.

“Small declines are expected as the continent battles both Omicron and higher energy prices. Further insights into German business sentiment comes with the German Ifo,” says Francesco Pesole, a strategist at ING, writing in a Friday research briefing. “A slightly softer dollar environment around the Fed could see EUR/USD trade up to the 1.1415/20 area, though we do not expect gains to last.”

Above: EUR/USD at daily intervals with Fibonacci retracements of September fall indicating likely technical resistances for Euro.