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30.06.2022 09:56 PM
EUR/USD. The Fed and the ECB are adjusting to the new reality: the dollar is still stronger than steel, and the euro seems to have lost its nerve

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In the pre-crisis era, many developed countries purposefully devalued their national currencies in order to gain competitive advantages in exporting goods.

In September 2019, Donald Trump, who was at the helm of the White House, once again criticized the Federal Reserve after the European Central Bank decided to reduce the interest rate on deposits even further into negative territory.

"They are making efforts and succeeding in reducing the value of the euro against a very strong dollar, which harms American exporters. And at this time, the Fed is sitting idly by," Trump said at the time, commenting on the reduction of the deposit rate in the eurozone to -0.5%.

As we remember, the Fed refrained from introducing a negative rate, but lowered it to almost zero, arguing this step, of course, not by pressure from the owner of the Oval Office, but by economic expediency.

Trump, in turn, praised the central bank's decision to reduce the key rate to almost zero, calling the changes that have occurred with the Fed phenomenal.

Leaving Fed Chairman Jerome Powell and his colleagues alone, Trump repeatedly criticized other countries, especially China, for what, in his opinion, they unnecessarily weakened their currencies and strengthened the dollar, making life difficult for American exporters.

Trump's presidency was even marked by his struggle with the so-called "currency manipulators".

However, the pandemic has changed the rules of the game. The era of targeting weaker exchange rates is over.

Amid inflation galloping everywhere, provoked by the disruption of supply chains and rising energy prices, developed countries have set a course to strengthen their currencies to reduce the cost of imports of critical goods. The period of raising rates has begun.

History shows that the central bank that raises rates the fastest and furthest supports its currency the most, since international capital is usually directed to where the yield is higher.

At the same time, the currencies of more dovish central banks and fragile economies are the most vulnerable.

The Fed's aggressive turn this year to curb historically high inflation by sharply raising interest rates, stopping new asset purchases and reducing its bloated balance sheet by more than $8 trillion has led to a rapid rise in the dollar.

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Since the beginning of the year, the greenback has strengthened against its main competitors by almost 10%, including against the euro by more than 8%.

Although the ECB is also facing record high inflation, it has been criticized for falling behind schedule, reacting too late and with timid steps.

The ECB remains with the lowest interest rate in the G10. While most of its colleagues are already starting a quantitative tightening program, the ECB is only now going to stop quantitative easing, Bank of America strategists say.

For the United States, the strengthening of the national currency may mean a drop in the competitiveness of its own products. However, this is only theoretically, but in fact the good news for America is that in 2020, exports of goods and services from the United States amounted to about 10.13% of national GDP. For comparison, the same indicator in the eurozone was 45.38%.

The currency bloc is currently watching its enviable current account surplus melt away as the cost of energy imports has soared in response to the conflict in Ukraine.

"Europe is experiencing a crisis in terms of trade. Energy prices in the eurozone are many times higher than in the United States, due to the EU's higher trade dependence on Russia and Ukraine and greater dependence on global energy imports," said Nomura strategists, who believe that there is a threat of further deterioration of the terms of trade for the eurozone.

Experts note that the risks of recession in Europe now seem to be growing faster than in America.

"So far, the economic cycles in the US and the eurozone have been almost synchronous, but recently there has been a discrepancy in the pace of slowing GDP growth on both sides of the Atlantic. Thus, the component of new orders fell to -1 in annual terms in the latest index of business activity in the currency bloc, which is a much more aggressive decline than in the United States," they said.

"If Russia stops gas supplies to Germany, it could be the biggest economic blow in modern history, apart from COVID-19 and the global economic crisis of 2008," Nomura said.

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The probability of gas rationing in Europe has increased significantly after the recent termination of Russian natural gas supplies via the Nord Stream-1 gas pipeline. A technical recession in the eurozone is now becoming more likely, analysts at Fitch Ratings said.

The EUR/USD pair fell to 0.64 by 1985 in response to the energy shock of the 1970s, analysts at Nomura recall.

They indicate that eurozone credit spreads are under pressure as the ECB considers raising interest rates.

This refers to the higher yields of Italian, Greek and Spanish government bonds compared to other more financially secure European countries, such as Germany.

"Credit spreads are getting wider, the periphery is still on a rocky path, the ECB's systemic stress indicator is at the level of March 2020, which can hardly indicate in favor of capital inflows to the eurozone," Nomura strategists said.

"In addition, inflation is deterring eurozone governments from accelerating joint bond issuance, which is widely seen as a means of ensuring stable financing of the currency bloc," they noted.

All this allows Nomura analysts to count on a drop in the exchange rate of the single currency against the US dollar to 1.0.

Does the euro have any hope?

The greenback is still standing confidently on its feet. This trend will continue until the Fed's policy tightening cycle ends, Westpac believes.

"The increasing risk of a recession in the US will periodically lower the USD exchange rate, but America has several trump cards up its sleeve, including $2.5 trillion of household savings accumulated during the pandemic. This, as well as the prospect of increased supply in the labor and goods markets should allow the United States to avoid a recession," the bank's specialists said.

"While America is struggling with supply side constraints and oversupply, Europe is dealing mainly with supply side issues and the outlook remains volatile. The US is operating more significantly ahead of its potential and capacity than the eurozone. Nevertheless, the rate markets expect that the monetary spread between the Fed and the ECB will change significantly by 2023," they added.

Westpac recommends buying the US currency in the 104 area and predicts that the medium-term upward trend in USD is likely to continue until the Fed's policy tightening cycle nears completion.

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The money market has softened expectations about the scale of the ECB rate hike. Therefore, the prospects for the euro have worsened, say Rabobank economists, who still believe that the EUR/USD pair will test the 2022 low in the area of 1.0350.

As of June 13, the money market predicted a peak in the ECB deposit rate at 2.48%, but reduced expectations to 2.04% as of June 27.

Amid increasing risks for gas supplies to the eurozone in winter, we expect that the region will fall into recession in late 2022 – early 2023. This not only indicates that the window of opportunity for the ECB to raise rates may be narrow, but also causes even more concern among the euro bulls. It also suggests that concerns about fragmentation in Europe are likely to intensify. We still see opportunities for EUR/USD to fall back to the annual low around 1.0350 in the future from one to three months," Rabobank said.

TD Securities analysts expect another decline in the EUR/USD exchange rate to the level of about 1.0300. At the same time, they believe that the pair should recover later this year.

"The near-term prospects for the euro remain difficult, which partly reflects the sluggish background for risk sentiment.

The wall of concern about European and global growth risks remains high, while China is just beginning to emerge from stagnation. Oil prices are another key factor that should be monitored in the coming months, and the decline in oil prices will have a positive impact on the euro," TD Securities noted.

According to the bank's forecast, the EUR/USD pair will stay in the range of 1.0300-1.0700, and then rise higher in the second half of the year.

Bank of America's medium-term estimates of the euro-dollar exchange rate suggest continued weakness of the single currency this year, but a gradual return to equilibrium is expected in the long term.

"We maintain our forecast for the EUR/USD pair for this year at 1.0500, which is still below the consensus forecast of 1.1000," the bank's strategists said.

Next year they expect to see the main currency pair at the level of 1.1500, in 2024 – about 1.2000.

"Our assumption is that the exchange rate will return to equilibrium in the long term, which in the case of EUR/USD is in the range of 1.2000-1.2500. However, uncertainty remains high even on the horizon of one year," Bank of America said.

Oh brave new world

The greenback strengthened against the euro by 0.8% on Wednesday.

According to Maybank analysts, the euro's decline against the dollar yesterday was caused by the market moving away from riskier assets after leading central banks warned of continued inflation and that they would prioritize the fight against it, which led to the growth of the USD wide front.

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Speaking at the ECB's annual forum in Sintra, ECB President Christine Lagarde said that she does not expect the global economy to return to the low-inflationary environment in which it has been in the last 10 years.

"I believe that the forces released as a result of the COVID-19 pandemic and as a result of the large-scale geopolitical shock that we are facing now will change the landscape in which we will be," Lagarde said.

At the same time, Lagarde did not voice fresh ideas about the next stage of the central bank's policy and refrained from committing to a specific rate hike in July.

Powell, who also took part in the forum, said that the COVID-19 pandemic has unleashed completely different economic forces, and it is still unclear whether the American economy will be able to return to a pre-crisis equilibrium.

The Fed's task is to find price stability in this new economy, he said.

When asked about the risk of recession, Powell explained that it would be an even bigger mistake not to restore price stability. He admitted that the central bank may go too far, provoking an economic downturn, but it seems that this is the price that the central bank is willing to pay.

Meanwhile, Cleveland Fed President Loretta Mester said FOMC officials must act decisively to curb price pressures.

According to her, the Fed is only at the beginning of raising rates.

Mester wants the base lending rate to reach from 3% to 3.5% this year and slightly above 4% next year, even if this could pull the economy into recession.

Prioritizing the suppression of inflation means a rapid increase in rates, and this is a boon for the dollar.

Inspired by the hawkish comments of the Fed representatives, the greenback rose sharply against its main competitors and ended Wednesday's trading as it approaches the 105 mark.

Meanwhile, the euro fell as if knocked down amid concerns caused by the "tough" position of leading central banks who are ready to fight inflation, even at the cost of slowing the economy.

The day before, the EUR/USD pair broke through the lower limit of the short-term consolidation range of 1.0500-1.0600 and finished around 1.0440.

On Thursday, the financial markets were dominated by capital flows associated with flight to safe havens, so the dollar easily overcame the round level of 105.00 and updated two-week highs around 105.20.

At the same time, the EUR/USD pair continued to slide down and sank to the lowest values since June 15 in the area of 1.0380.

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"Since the middle of the month, the euro has failed to break through the 1.0600 area three times, which left players no choice but to retest the 1.0400-1.0350 support zone," Scotiabank analysts noted.

However, the greenback quickly lost the points gained, thanks to which the EUR/USD pair managed to gain momentum of recovery during the US session and jumped by more than 100 points.

The impetus for the USD decline was the release of data on basic personal consumption expenditures in the United States, which did not meet expectations of 0.4%, amounting to 0.3% M/M for May. The indicator for the year reached 4.7% against the projected 4.7%.

A slip of 0.1% was the reason for profit-taking on the dollar. The cash flows typical for the end of the month and the quarter also played their role. However, this does not change the overall picture.

The main driving force in the EUR/USD pair remains the dollar, and it still tends to grow. The US currency's current retreat looks more like a correction after a two-day rise of 1.5% than a change in the exchange rate.

The euro has received a breath of fresh air, but after adjusting positions at the end of the quarter, it will return to the new reality outlined yesterday by the leading central banks.

The initial resistance for the EUR/USD pair is at 1.0470 (the Fibonacci retracement level is 23.6%). If the pair fails to recover higher, it may retest the round level of 1.0400, the end point of the last downward trend at 1.0380, as well as the June low at 1.0360.

On the other hand, the pair may grow to the psychologically important mark of 1.0500 and 1.0520 (38.2% Fibonacci retracement level) if the bulls manage to turn 1.0470 into support.

Viktor Isakov,
Especialista em análise na InstaForex
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