EUR/USD Week Ahead Forecast: Hampered in Holiday Market Conditions

• EUR/USD momentum ebbs near 8-month highs  
• Could struggle for traction above 1.06 this week
• Speculative profit-taking may hamper short-term
• Aids risky assets but weighs on EUR/USD longs
• U.S. PCE data eyed; thin, choppy trade possible

Image © European Union - European Parliament, Reproduced Under CC Licensing. 

The Euro to Dollar exchange rate reached eight-month highs last week but could struggle for traction this week if profit-taking or book-squaring ahead of the festive holiday leads the speculative market to reduce its exposure to the single currency, which is one of the market's few 'net long' positions. 

Europe's single currency benefited last week when a second fall in U.S. inflation left the Dollar unable to capitalise when the Federal Reserve lifted its forecasts for inflation next year as well as the likely peak in U.S. interest rates.

EUR/USD reached eight-month highs above 1.07 shortly after last week's Fed decision but its short-lived rally was scuppered when the European Central Bank (ECB) set out its most hawkish policy position yet but also triggered a stock and bond market rout in the process. 

"The ECB is essentially focussed on destroying demand in the Eurozone economy in order to bring inflation lower, even though much of the inflationary pressures in the Eurozone had stemmed from higher energy and food prices," says Jane Foley, head of FX strategy at Rabobank. 

"Given the risk that the ECB’s mission to extend policy tightening ‘significantly further’ threatens to squeeze the life out of the economy, the EUR may struggle to extend its recent gains into 2023," Foley writes in a Friday review of the outlook for the single currency.

Above: Euro to Dollar rate shown at hourly intervals with Fibonacci retracements of late November rally indicating possible areas of short-term technical support. Click image for closer inspection. 

President Christine Lagarde's warning that "interest rates will still have to rise significantly at a steady pace to reach levels that are sufficiently restrictive to ensure a timely return of inflation to our two per cent medium-term target," pulled a metaphorical rug from under the feet of risky assets. 

The statement made clear that the ECB intends to use its interest rate to squeeze inflation out of the Eurozone irrespective of the costs to the economy, which is a stance that could leave some investors leery of the single currency.

"We have long maintained that the ECB is limited in its ability to support the currency through more aggressive policy tightening, especially because QT in the Euro area means less support for sovereign credit, which is negative for the currency on the margin," says Michael Cahill, a strategist at Goldman Sachs.

"This creates a difficult environment for European risk assets to digest the ECB’s actions, and will continue to deter active portfolio flows, in our view. As a result, we continue to expect the Euro to underperform in the near term, even as cooler inflation readings in the US limit potential Dollar upside," Cahill adds.

While last week was all about central bank policy decisions, pre-holiday position squaring might be a more dominant influence in the days ahead though with uncertain implications for the Euro, which has recently become the speculative market's sole 'long position' among G10 currencies.

Above: Euro to Dollar rate shown at daily intervals with Fibonacci retracements of April 2022, June 2021 and January 2021 downtrends indicating possible areas of short-term technical resistance for Euro. If you are looking to protect or boost your international payment budget you could consider securing today's rate for use in the future, or set an order for your ideal rate when it is achieved, more information can be found here. 

The risk is this week of speculative market participants scaling down trading exposures going into the illiquid market conditions that typically prevail ahead of year-end and in the case of the Euro, this would imply cutting back 'long' exposure and a headwind for the Euro-Dollar rate.

"We suspect EUR will continue to climb higher in the weeks ahead, and we remain long EUR/USD (targeting 1.10 at end-January)," writes Jordan Rochester, a strategist at Nomura, in a Friday research briefing.

"However, we will keep an eye on whether there are any challenges to the peak inflation narrative in the US, whether European growth takes a turn for the (even) worse and whether the UK remains the canary in the coal mine for central bankers elsewhere with the rising risk of defaults," he adds. 

With trading activity likely to thin out over the coming days, there is uncertainty over the likely response to this week's offering from the U.S. economic calendar, which includes the latest reading of the Personal Consumption Expenditures (PCE) inflation gauges on Friday.

These are the Fed's preferred measure of inflation while economists and financial markets will be looking to see them confirm the declines seen in the last two readings of the official consumer price index measures of inflation.