Euro-Dollar Upside Limited as Central Bank Showdown to Favour USD Says Rabobank

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The Euro extends a recovery against the Dollar ahead of this week's central bank meetings but analysts at Rabobank are not convinced the recovery will be sustained for a prolonged period.

The Dutch-based international investment bank and lender says the European Central Bank (ECB) could signal on Thursday it is closer to the end of its rate hiking cycle, but the U.S. Federal Reserve looks set to deliver a 'hawkish' hold.

The ECB will raise interest rates by 25 basis points on Thursday and Jane Foley, Senior FX Strategist at Rabobank, says the key focus for foreign currency markets will be on the new staff economic projections and the signals provided by the central bank.

She notes that the market will assess not only the projected peak level of interest rates but also their expected duration.

"It is widely assumed that the ECB is closing in on the end of its rate hiking cycle, meaning that the market will be trying to evaluate not just how high rates will go, but how long they will remain at their peak," says Foley.

Recent indications of softer CPI inflation readings in several Eurozone countries and a slowdown in Germany's manufacturing sector have raised doubts about the proximity of the peak in ECB rates.

"Signs of softening in CPI inflation readings for various Eurozone countries and a weakening in Germany's manufacturing sector have raised questions as to how close the peak in ECB rates is," says Foley.

The market has already priced in two more 25 basis point rate hikes from the ECB during this cycle. This comes as the Euro to Dollar exchange rate (EURUSD) records a 0.43% rise already this week as it builds on the previous week's 0.30% advance, to now quote at 1.0790.

Foley suggests that for the Euro (EUR) to make sustainable gains following the policy meeting, the ECB's hawkish signalling would have to be surprisingly strong. "This suggests that for the EUR to make sustainable gains on the back of this week's policy meeting, the hawkish signalling would have to be surprisingly strong," she says.

Meanwhile, market participants will also digest fresh signals from the Federal Open Market Committee (FOMC) meeting on Wednesday.

While steady policy is expected from the Federal Reserve (Fed), Foley believes that the door will be left open for a rate hike in July.

Above: The EURUSD's recent recovery in context.

She notes that recent economic indicators such as PMIs, factory orders, ISM data, and initial jobless claims have suggested a potential slowdown in the U.S. economy.

However, she highlights the ongoing resilience of the U.S. economy following a prolonged period of tightening by the Fed.

"The latest release of the PCE deflation data, which is the Fed’s favoured measure of inflation, actually rose in April," says Foley. "While there are signs that the U.S. labour market is loosening, it remains tight from a historical basis."

Considering these factors, Foley sees a risk of a 'hawkish hold' in policy rates, which could support the U.S. dollar (USD).

"We see risk of a 'hawkish hold' in policy rates this week, which should be USD supportive," she says.

Despite the recent recovery in EURUSD above 1.07, Rabobank maintains a target of EUR/USD 1.06 for the second half of the year.

Foley suggests that the ECB may keep its 2025 inflation projection slightly above the target to counter market forecasts of rate cuts early next year. However, she expects the EUR to face challenges in sustaining gains against the greenback amid a 'higher for longer' theme from the Fed.