Euro / Dollar Weathers the Storm, Facing Brighter February

• EUR/USD lifts off recent floor
• ECB meeting poses upside potential
• USD could revert lower in Feb. say some analysts

Above: File image of Italian Prime Minister Mario Draghi. Image © European Central Bank, reproduced under CC licensing.

The Euro to Dollar exchange rate could be set to appreciate over the duration of February with strategists saying the Dollar will face headwinds as U.S. rate expectations recede and the markets sense the European Central Bank is ready to bring forward the timing of its first interest rate hike.

The Euro was meanwhile lifted at the start of the new week as markets cheered developments in Italy where pro-market reformist Mario Draghi looks set to continue as Prime Minister following the reelection of President Sergio Mattarella in recently held national elections.

Commentators say the election result offers the prospect of continuity and stability, leaving Draghi free to push ahead with the policy overhauls required by Italy’s €200BN EU-funded reform and investment plan.

"There was good news for markets over the weekend. In Italy, Sergio Mattarella was re-elected as president for a second term which, in turn, means Mario Draghi will remain in place as Prime Minister most likely until elections due early in 2023," says Daragh Maher, Head of U.S. FX Strategy at HSBC.

A rally in the Euro means the EUR/USD exchange rate has risen off its recent multi-month low, achieved just last week.

Above: EUR/USD chart shown at four hour intervals showing a dominant downtrend.

• EUR/USD reference rates at publication:
  Spot: 1.1237
• High street bank rates (indicative band): 1.0844-1.0922
• Payment specialist rates (indicative band): 1.1136-1.1180
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Although chart trends still look to favour the U.S. Dollar in the short-term much will reside with the European Central Bank (ECB) policy meeting, due Thursday 03.

No radical change in policy is expected to come out of the ECB, although investors will be keen to hear what the central bank's latest thinking on inflation will be.

The market sees a chance the ECB raises rates at the end of 2022 and for the Euro the outlook could depend on whether policy makers validate this expectation.

"While the ECB isn’t expected to make any rate changes this week or anytime soon, the euro could rebound if policymakers sketch a more hawkish outlook for policy, should inflation prove persistently high," says Joe Manimbo, Senior Market Analyst at Western Union.

Christopher Romano, a Reuters market analyst, says falling Euribor prices indicate investors are pulling forward expectations for an ECB hike and a December 2022 hike looks likely and the prospect of a September hike is growing.

German 10-year yields are meanwhile near a 32-month high of 0.029% in acknowledgement of these expectations, which could allow the gap between German yields and their equivalent U.S. yields to close in an EUR/USD supportive direction:

Above: "EURUSD vs. Germany/USA 5-year rate differential" - Spectra Markets. Image courtesy of Spectra Markets.

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The ECB is likely to maintain ultra-dovish credentials and warn inflation will start to fall again in 2022 and that there is little risk inflation stays stuck above their 2.0% target on a sustained basis.

But even if the ECB sticks to its well worn script the Euro-Dollar exchange rate could continue to recover.

This is because the Dollar has started the month on a soft note and there is a risk the strong buying interest that followed the Fed's January policy update is unwound over coming days, in favour of EUR/USD upside.

"EUR/USD appears to have weathered the initial storm from last week's Fed meeting, and rates markets along with ECB expectations indicate potential upside risks ahead," says Romano.

Reuters data shows the U.S. rates market appearing to be taking a less hawkish view with the passage of time.

Euro-dollar interest rates appear to be holding near the 2.0% from the end of 2023 out to the end of 2027.

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The U.S. 2-year yield rally has paused while 10-year yields have erased most of the Jan. 26 Fed-induced gains, which now has the U.S. 2s-10s yield curve threatening support near 0.5850 bps.

"Further erosion of the dollar's yield advantage would bolster EUR/USD upside risk," says Romano.

For one strategist a number of factors suggest the Dollar is vulnerable at the start of February.

"To me, this is setting up as a spectacular place to take a shot at short dollars. You have all sorts of things going on that suggest it’s a good tactical entry," says Brent Donnelly, CEO of Spectra Markets.

Donnelly says the January month-end period has been dominated by significant Dollar buying, but now that this has passed the market could be ready to sell Dollars.

Donnelly finds that the foreign exchange market can tend to revert on the moves seen in January, therefore USD strength must unwind.

In January the Dollar appreciated by about 1.0% against the Pound and nearly 2% against the Euro.

Donnelly also finds U.S. data is slowing, "because of the fiscal cliff, not omicron."

And importantly the boost to U.S. yields afforded by last week's Federal Reserve meeting will start to unwind says Donnelly, meaning U.S. rates will therefore start to converge with rates elsewhere.