EUR/USD Week Ahead Forecast: Retesting 1.02 if All Goes Well for ECB  

• EUR attempting recovery as USD corrects lower
• Could look to reclaim 1.02 if all goes well for ECB 
• But gas flows & Southern bond markets are risks

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The Euro to Dollar exchange rate rallied from below the one-for-one level ahead of the weekend and could rise further in the days ahead in an attempted recovery of the 1.02 handle if everything pans out well for the European Central Bank (ECB) and Eurozone economies this Thursday. 

Europe’s single currency succumbed briefly to the sheer weight of gravity whipped up by the bearish currency market when trading below parity with the Dollar for the first time since 2002 last week but later staged a notable rally that saw it end the period closer to the 1.01 handle. 

That was after Federal Reserve rate setters including Governor Christopher Waller, St Louis Fed President James Bullard and Atlanta Fed President Raphael Bostic appeared to pour cold water over the momentarily popular notion that the Fed could lift U.S. interest rates by 1% later in July.

“There is perhaps a greater recognition that an accelerated pace of tightening might cause further financial stress, which might aggravate slowdown worries,” says Eugene Leow, a senior rates strategist at DBS Group Research. 

Above: Euro to Dollar rate shown at hourly intervals alongside AUD/USD and NZD/USD. Click image for closer inspection. 

The idea of a full percentage point U.S. rate rise took hold after the Bank of Canada opted for the same last Wednesday and following inflation data for June that suggested the journey back to the Fed’s 2% target could be longer than many had given credit for.

But a prompt rebuttal by Fed rate setters and later flurry of better-than-expected U.S. economic figures deflated the Dollar and revived the Euro ahead of the weekend while begging the question of whether the greenback could soften further in the days ahead. 

To the extent that it does, the Euro to Dollar rate could continue to benefit, although by far the most important determinants of the outlook for the single currency will be this Thursday’s ECB policy decision and concurrent developments in European natural gas markets.  

“The main upside risk to our trade idea in the week ahead would be if the ECB delivers more front-landed tightening by hiking rates by 50bps, and the ECB’s anti-fragmentation policy tool plans are viewed favourably by market participants. ,” says Lee Hardman, a currency analyst at MUFG.

"In contrast, if the ECB’s anti-fragmentation policy tool plans disappoint and/or Italy moves closer to an early election, the fundamental case for a weaker EUR would be reinforced“,” Hardman and colleagues said on Friday after reiterating a recommendation to sell EUR/USD.

Above: Euro to Dollar rate shown at 4-hour intervals with Fibonacci retracements of early July declines indicating possible areas of minor and short-term technical resistance for Euro. Click image for closer inspection. 

A planned vote in the Italian parliament is set to determine on Wednesday if there will be an early election in Italy, which many analysts say would be a downside risk for the Euro, and just before Thursday’s anticipated resumption of Russian natural gas flows through the Nordstream 1 pipeline. 

Whether those gas flows return following an ongoing 10-day maintenance shutdown will be a significant influence on the outlook for European economies as well as for the ECB’s interest rate policy in the months ahead. 

“Gas rationing, owing to interrupted Russia imports implies 1970s-style stagflation in Europe. It could trigger several quarters of European recession and we estimate a peak impact on GDP around 2.5pp below our baseline forecast,” says Camille de Courcel, head of G10 rates strategy at BNP Paribas.

“We would expect the ECB to hike by 100bp this year (vs. 150bp in our central case). With the market pricing in an ECB policy rate of 1.25% by May 2023 and no rate cuts, risk remains tilted to the downside for the EUR front end, in our view,” de Courcel and colleagues said on Friday. 

The ECB effectively pre-announced in June that it would lift its interest rate for the first time in more than a decade this Thursday before pledging to follow up with further increases in the months ahead, but the Euro has not been able to capitalise on this landmark shift in ECB policy thus far.

Above: Euro to Dollar rate shown at daily intervals alongside AUD/USD and NZD/USD. Click image for closer inspection. 

The strong Dollar and investor pessimism about the global economic outlook have been relevant but far more important has been market concerns about stability in the bond markets of Southern Europe including Italy’s as the ECB’s interest rate normalisation cycle gets underway. 

These fears, combined with risks to Europe’s energy supply, have been crippling for the Euro in recent weeks but there is a chance - if not a likelihood - that Thursday will see concerns on both fronts eroded resulting in scope for the single currency to reverse some of it heavy July losses. 

“The path is set for next week (and for September): a 25bp hike is all but certain -- followed by a 50bp rise after the summer,” says Giovanni Zanni, chief Euro Area economist at Natwest Markets. 

“ECB’s communication in recent weeks has been consistent with the gradual path suggested at the June meeting despite rate hike upside surprises elsewhere. Beyond these first steps, forward guidance is scant,” Zanni and colleagues said on Friday.

The Euro could be especially likely to benefit this week if the anticipated details of the ECB’s Transmission Protection Mechanism - a new tool designed to support Southern European bond markets as the bank’s interest rates rise - are able to address the concerns of investors.

Should such an outcome be combined with a further softening of the U.S. greenback over the course of the week then it could be enough to dispel recently mounting expectations for the Euro-Dollar rate to slide sustainably below the one-for-one level.

Above: U.S. Dollar Index shown at monthly intervals with Fibonacci retracements of 2002 downtrend indicating possible areas of short and medium-term technical resistance. Click image for closer inspection.