EUR/USD Risk Tilting Higher into ECB Decision after Fed Rate Outlook Revised

"There are not many other economies that can match the Fed’s higher aim (and possibly faster pace) as well as the Euro area right now" - Goldman Sachs.

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The Euro to Dollar exchange rate has bounced sharply from the year's lows in recent trade but the balance of directional risk remains tilted to the upside ahead of Thursday's European Central Bank (ECB) interest rate decision owing in part to a sharp repricing of the Federal Reserve (Fed) policy outlook. 

Europe's single currency has been a prominent beneficiary of broad declines in Dollar rates since funding pressures at some small U.S. lenders began snowballing into the weekend failures of Silicon Valley Bank and others, which has prompted a market rethink of the outlook for Fed and ECB policies.

"If the ECB foregoes a 50bps hike this week or wavers on its pre-commitment to a follow-up move in May, FX investors will interpret the dovish response as a clear indication of panic," says Stephen Gallo, European head of FX strategy at BMO Capital Markets. 

"Alternatively, a continuation of unapologetically hawkish policy could dent risk appetite. Assuming the FX market remains on tenterhooks for the remainder of the week, I would expect this dynamic to cap EURUSD rallies at 1.0800," he adds in Tuesday market commentary. 

Above: Euro to Dollar rate shown at 2-hour intervals alongside GBP/USD. Click image for closer inspection.

While a federal 'resolution' of the fallen firms is being carried out "in a manner that fully protects all depositors" while providing "access to all of their money," analysts and economists say the psychological shock of these events is likely to stifle overall bank lending and the economy itself up ahead.

Hence why economists and markets have revised expectations of the Federal Reserve this week to imply uncertainty about whether it will even raise interest rates at all this March or over the subsequent months, which has had a knock-on effect on market pricing of the ECB policy outlook. 

"I think we need to be cautious when interpreting the immediate path for Fed policy being assigned by the FX market," Gallo says.

"Medium-term: I think recent events reinforce the view that the peak for the USD this cycle is already in. Moreover, the terminal rate for the Fed will probably be lower than it would have been in their absence. There is probably a dampening story for lending growth and inflation here too," he adds.

Above: Euro to Dollar rate shown at 4-hour intervals alongside GBP/USD. Click image for closer inspection. To optimise the timing of international payments you could consider setting a free FX rate alert here.

While there has been a spillover from interest markets in the U.S. to those elsewhere in recent days, the small bank funding problems were entirely symptomatic of the distinctly and increasingly hawkish interest rate stance maintained by the Fed in prior months.

That had led financial markets to bet as recently as last week that U.S. interest rates would rise as far as 5.75% before year-end, making for a 550 basis point increase since this time last year, while implied expectations of the ECB had been much more modest. 

"The retrace in pricing for the ECB this week, last +38bps, is a fair reflection of caution, though consensus remains for the well-telegraphed 50bps to be delivered," writes Patrick Bennett, head of Asia FX strategy at CIBC Capital Markets, in Tuesday market comments. 

"EUR/USD support is now 1.0675 and resistance is 1.0800-05," he adds. 

Above: Euro to Dollar rate shown at daily intervals alongside GBP/USD. Click image for closer inspection. (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.)

With this there is risk of the market being mistaken in doubting whether the ECB will deliver another half a percentage point increase in its own interest rates on Thursday, as was almost preemptively announced in February.

This could mean Thursday's policy announcement is an upside risk for the Euro to Dollar rate ahead of the weekend but particularly if the Governing Council remains of the view, and maintains its guidance, that further increases in borrowing costs are still likely to be necessary beyond March. 

"The Euro area stands out because, given more persistent inflation pressures and the elevated pace of nominal growth, the economy likely requires and can withstand faster hikes," says Michael Cahill, a strategist at Goldman Sachs. 

"There are not many other economies that can match the Fed’s higher aim (and possibly faster pace) as well as the Euro area right now. For this reason, we think the Euro can still be somewhat resilient in a more indiscriminate period of Dollar appreciation," Cahill and colleagues say in a Friday research summary.

Above: Euro to Dollar rate shown at weekly intervals alongside GBP/USD. Click image for closer inspection. To optimise the timing of international payments you could consider setting a free FX rate alert here.

Last time out in February the ECB's guidance was that interest rates would likely continue to rise in half percentage point increments "at the coming meetings" so as to help insure that inflation makes a timely return to the 2% target.

Meanwhile, economic data out since then has done nothing to discourage that policy prescription while Eurostat confirmed late last month that continental inflation pressures only grew more stubborn in February, suggesting the ECB might be likely to stay its original course on Thursday. 

"From an FX perspective, this would be good news for the euro, but: a) a repricing higher in rate expectations would still require President Lagarde to convince markets at the press conference (which will prove exponentially more challenging given recent developments); b) rate differentials remain an absolute secondary driver of EUR/USD," says Chris Turner, global head of markets and regional head of research for UK & CEE at ING. 

"The direction for the pair is set to be determined almost solely by how the Fed reacts – or “overreacts” – to the SVB fallout. For now, we target 1.08-1.09 by the end of this week," Turner and colleagues write in a Tuesday research briefing.