G10 FX Weekly: Fade EUR/USD Downside and Prepare for Upside

Summary

• Countervailing narratives for the EUR/USD currency pair in the past year have led to whippy price action and sharp moves.
• Sentiment around Europe’s ability to weather the economic challenges from the war in Ukraine has driven, and will drive, the pair’s direction.
• Improving euro-area fundamentals will also influence EUR/USD price action.

Market Implications

• EUR/USD is currently a ‘classic trader’s market’, with two-way price action set to dominate in the coming weeks and months.
• The ~1.05-1.10 range established so far this year will probably hold in the coming weeks, meaning that we favour fading the extremes in this range.
• Longer term, the pair can grind higher, nearer the ~1.13 level seen before the war in Ukraine, as European fundamentals improve.

Introduction

EUR/USD is the most heavily traded currency pair in foreign exchange (FX) markets, accounting for ~23% of turnover globally. As such, it is a critical component in the FX world and always worth analysing.

The pair has been under intense scrutiny since Russia’s invasion of Ukraine, and it has acted as the first outlet for markets to express a view on the economic consequences of the war. For much of last year, the euro fared badly versus the US dollar.

In this piece, we will focus on three drivers of price action in EUR/USD – geopolitics, interest rate differentials, and European economic fundamentals.

In the near term, we expect the pair to respect the recent ~1.05-1.10 range, with a breakout unlikely in the coming weeks. In the medium and long term, however, we are cautiously optimistic about the euro.

Geopolitics Remains the Critical Input

The war in Ukraine has had a huge negative impact on EUR/USD (Chart 1).

Energy Prices Have Driven EUR/USD

The intuition behind this price action was that Europe’s reliance on Russian oil and gas would massively drag on the European economy. In the war’s early months, energy prices skyrocketed, sanctions were imposed, and the immediate future looked grim.

Many forecasts predicted a very difficult winter, including energy rationing and potential blackouts. In the currency markets, this led to heavy selling of EUR/USD, taking the pair to a ~20-year low, trading below the important psychological parity level.

As winter approached, however, the price action shifted. This might have been partly because short positioning was incredibly crowded, and a short squeeze took traders out of their bearish euro positions.

Luck Helped the Euro Recovery

An even bigger factor, however, was luck. The weather over the past few months in Europe has been milder than usual, meaning the region’s energy demand has been considerably lower than expected.

This weaker energy demand has led to lower prices. In the past week, European gas prices fell below €50 per megawatt-hour for the first time since September 2021 (Chart 2).

This trend of lower energy prices has existed since last summer, and prices are now returning to pre-war levels. This price turnround coincided with the reversal higher in EUR/USD. As energy prices decreased, the value of the euro versus the dollar has risen.

Geopolitical Risks Persist

Geopolitical risks remain and could still weigh on the euro. As my Macro Hive colleague Henry Occleston wrote recently, geopolitics matters greatly.

Specifically, Henry highlights three key near-term geopolitical risks: an isolated and vulnerable Iran, trouble around Turkey’s elections, and further Russian escalation of its war against Ukraine.

Henry argues that markets are almost certainly under-pricing these potential geopolitical risks, that subsequent flashpoints are high-risk, and that such events may unfold rapidly.

For EUR/USD, an escalation in any of Henry’s three scenarios would weigh heavily on the euro, as each could disrupt energy supply chains and drive oil and gas prices higher.

This would be a massive negative for the euro area, as much of the prospective geopolitical risk is on Europe’s doorstep.

Europe Has Become Less Reliant on Russian Energy

Having said that, the European Union (EU) is aggressively diversifying its energy supply away from Russia. While some vulnerability is still embedded in the current situation, it is considerably less than when the war began.

Recently, the EU has barred imports of Russian fuels such as diesel and gasoline, following the earlier halt of Russian crude imports and coal. Natural gas imports from Siberia have slowed considerably, as well.

Europe has weaned itself off Russian energy supply almost entirely. It completed a process that would ordinarily have taken decades in under a year.

Simultaneously, Europe has scrambled to stockpile fuels and establish alternative supply sources. The mild winter has helped the stockpiling efforts. Clearly, diversifying away from Russian supply is making impressive progress.

While there will be glitches and bumps in the road ahead, the stark contrast between now and one year ago is noteworthy. Europe’s economy is less dependent on Russian supply and less vulnerable to geopolitics. This is good for the euro.

EUR/USD – The Near-Term Prognosis

Since the beginning of the year, EUR/USD has traded in a very tight ~1.05/1.10 range.

Although there is potential to breach the extremes of this price band (with the pair looking more likely to grind towards and through 1.05), we would expect the range to broadly hold in the coming weeks and look to fade the extremes.

The impressive economic data flow in the US this month has massively impacted pricing in the short end of the US rates curve, with yields pushing much higher.

For example, the implied yield on the December 2023 Fed Funds futures contract has risen over 60bp since 2 February, reflecting the market’s more hawkish tilt on Federal Reserve (Fed) rate expectations.

The implied yield on the December 2023 Euribor futures contract has also risen, about 40bp, although not as sharply as in the US.

With these relative moves in short-end rates, you could reasonably expect a sharp downside move in EUR/USD. We would argue that the move lower has been muted, and that this shows a more resilient euro than that of H2 2022.

And, with the European Central Bank (ECB) expected to keep pace with, if not outpace, the Fed this year in tightening monetary policy, it should provide additional support to EUR/USD in the coming months.

EUR/USD – The Medium- and Long-Term Prognosis

Beyond this, improving fundamentals will also support EUR/USD and could eventually lead the pair back to the ~1.13 level from before the war.

Europe’s Economy Is Improving

In H2 2022, economic forecasts for the euro-area were quite dreary – as outlined above, the consensus was that the Russia-Ukraine war would slam the European economy.

Economic expectations are now more optimistic. Just last week, the European Commission revised its economic forecasts upwards, while saying inflation has peaked.

Given the doom and gloom of a few months ago, this brighter prognosis should support EUR/USD ahead.

Capital Flows Are Becoming Euro-Positive

Another additional support for the euro comes from capital flows. The net outflows from the euro-area, driven largely by the sub-zero yields, which until recently dominated the investment landscape, have reversed, according to data compiled by Deutsche Bank.

Deutsche said that ‘underlying flow dynamics are turning dramatically more positive for the euro this year … Money managers are telling us they’re seeing waves of investment flows into European fixed income for the first time in a long while.’

Flows matter. And, while these flows will not necessarily result in one-way traffic towards the euro-area, the old adage ‘the trend is your friend’ is probably worth heeding ahead. With greater interest in the European bond markets, the currency will benefit.

Conclusion

The biggest driver of EUR/USD over the past year has been the war in Ukraine. And, while initially the price action was decidedly and understandably bearish, the euro has rebounded impressively off its lows.

This is partly due to luck, as a milder-than-expected winter has helped Europe avoid the worst-case scenario of an energy crisis and deep economic recession. This result has benefited the euro.

Looking ahead, EUR/USD will probably continue to trade within its year-to-date range of ~1.05-1.10. Beyond this, however, the pair could trade back towards its pre-war level, at 1.13. We think this level is much more likely than revisiting the recent lows below parity.

Richard Jones is a Macro Strategist for VDK Capital, a London-based venture capital firm. He has traded and invested in interest rate and FX market portfolios spanning three decades, both on the buy-side and sell-side. 

Photo Credit: depositphotos.com

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)