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Euro gains strength as ECB moves in a more hawkish direction

Home >  Daily Market Digest >  Euro gains strength as ECB moves in a more hawkish direction

Written by:
Myrsini Giannouli

20 May 2022
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Important calendar events

  • EUR: German PPI, Consumer Confidence
  • GBP: GfK Consumer Confidence, Retail Sales, MPC Member Pill Speaks
  • All: G7 meetings

USD

The dollar reached a 20-year high last week, with the dollar index climbing to 104.97. The US dollar, surpassed its pandemic high of 2020 last week, supported by hawkish Fed monetary policy and strong inflationary pressures. US yields also remained high last week, with the US 10-year treasury note yielding above 3%. 

The risk-aversion sentiment was renewed on Thursday, driving stock markets and high-risk assets down. Retail stocks from Target and Walmart declined heavily this week, while technology stocks, such as Amazon, Tesla and Apple were also down. Stock markets rebounded later on Thursday, led by tech stocks, although the dollar continued to decline.

This week the dollar has been slipping, with the dollar index falling to 102.7 on Thursday. Market sentiment was unstable this week, while the dollar’s high price tempted traders to close long positions, realising their profits. The USD, which has been trading into overbought territory, softened this week, also weakened by the lack of support from Treasury yields. Bond yields declined, with the only exception being the 1-year note, while the US 10-year treasury note yielded approximately 2.8% on Thursday.

US Financial and employment indicators released on Thursday were negative for the state of the US economy, driving the dollar further down. On Tuesday, Core Retail Sales and Retail Sales data showed that consumer spending is increasing despite the high inflation rates, indicating that economic activity is not stalling in the US as feared. 

Fed Chair Jerome Powell stated on Tuesday that the Fed would keep raising interest rates until inflation comes down. In addition, Fed member John Williams stated on Monday that tackling high inflation rates should be the Fed’s top priority. Even though Fed rhetoric continues to be hawkish, the USD is on the decline as it has been overbought in the past few months.

The dollar has been boosted by hawkish Fed policy and increased risk-aversion sentiment. Continued Russian hostilities against Ukraine have increased risk-aversion sentiment these past two months, providing support for the safe-haven dollar. As there is still no end in sight to the crisis, the dollar’s appeal as an investment remains high. 

In its latest monetary policy meeting, the US Federal Reserve raised its benchmark interest rate by 50 base points to 1%. This is the first time that the Fed has performed such a steep rate hike since 2000. The Fed has also announced that it would move towards a policy of gradual quantitative tightening. The Fed’s balance sheet has risen to approximately 9 trillion USD during the pandemic and the US Central Bank has decided to start trimming its balance sheet.

TRADE USD PAIRS

EUR 

The Euro gained strength against the dollar on Thursday, catapulting the EUR/USD to the 1.060 level. If the currency pair goes up, it may encounter resistance at 1.064 and further up at 1.093. If the currency pair falls, it may encounter support at the 1.036 level which represents 2016 low and further down near a 20-year low of 0.985.

Increased risk-aversion sentiment and hawkish Fed policy have been boosting the dollar these past few weeks at the expense of other currencies, with the Euro suffering heavy losses. This week, however, the dollar is softening and the Euro has taken advantage of its weakness.

Clear indications from the ECB that it would move towards a more hawkish policy this year, have also boosted the Euro. Markets are now pricing in up to 100 base points rate hikes throughout the year. Many of the ECB’s members are in favour of taking aggressive steps towards monetary policy normalisation. ECB President Christine Lagarde is in favour of a more dovish stance but has recently shown signs of wavering, stating that the ECB will likely end its bond-buying programme in the third quarter of 2022 and a rate hike might follow just a few weeks later. 

ECB members are starting to agree on a more hawkish policy starting in the third quarter of the year and the consensus between them seems to be that the ECB will perform its first rate hike in decades at its next policy meeting in July. The US Federal Reserve has raised its benchmark interest rate by 50 base points to 1%, highlighting the difference in monetary policy between the EU and the US and has been driving the Euro down. 

On Tuesday, ECB President Christine Lagarde delivered a speech at a charity event in Germany, emphasizing the role of national central bank chiefs. ECB Member Francois Villeroy stated on Monday that he is in favour of a decisive June meeting and that an active summer should be expected in terms of the ECB’s monetary policy, further raising expectations of a shift towards a more hawkish policy.

Annual Final CPI and Core CPI data were released on Wednesday for the Eurozone, putting pressure on the currency. The CPI data are key indicators of consumer inflation and can have a strong impact on the Euro as they can influence the ECB’s decision to raise its interest rates. Headline inflation in the Eurozone was slightly lower than expected, reaching 7.4% in April, while core CPI was at 3.5% and fell within market expectations. Investors were expecting higher EU inflation rates for April, as increasing energy costs are augmenting inflationary pressures. Markets reacted to the release of the inflation indicators with a fall in the price of the Euro, which had already retreated ahead of the CPI data. 

On Tuesday, higher than expected Flash GDP data raised hopes that the Eurozone economy is moving in a positive direction. EU economic forecasts released on Monday showed that Eurozone inflation forecasts were increased to 6.1% in 2022, while growth projections were lowered. Even though economic conditions in the EU are not improving as much as expected, high inflation rates support the Euro, as they increase the chances of an ECB rate hike later in the year. 

Minor economic indicators are scheduled to be released for the Eurozone on Friday, which is not expected to affect the Euro significantly.

EURUSD 1hr chart

TRADE EUR PAIRS

GBP

The sterling climbed on Thursday, taking advantage of the weakening dollar, with the GBP/USD rate reaching the 1.25 level. If the GBP/USD rate goes up, it may encounter resistance at the 1.263 level and further up near the 1.331 level, while if it declines, support may be found near the two-year low at 1.206. 

This week, the dollar has been pushed down from its 20-year highs, due to a combination of unstable market sentiment and probable profit-taking on long positions. Other assets have profited from the dollar’s weakness, although the sterling has been under pressure from renewed risk-aversion sentiment.

Several important economic indicators were released this week for the sterling, including Annual CPI and Core CPI, Monthly PPI Input and Output, Annual RPI, and Annual HPI. CPI data are key indicators of consumer inflation and showed headline inflation rose to 9% in April, while core inflation hit 6.2%. Headline inflation reached a new 40-year high, highlighting the need for legislative action to tame soaring inflation rates. 

Markets typically react to news of high inflation in favour of the currency, as high inflation rates may increase the probability of the BOE moving towards a more hawkish direction. Current economic conditions however are fragile, and soaring inflation rates add more pressure to struggling British households, which could lead the BOE to move towards alleviating the cost of living in the UK. After the release of the CPI data, the GBP was crushed.

The UK jobs sector seems to be recovering from the effects of the pandemic, as employment data released this week indicate that the unemployment rate is going down, hitting its lowest level in nearly 50 years.

UK Monetary Policy Report Hearings also took place this week, at which the BOE Governor and several MPC members testified on inflation and the economic outlook before the Parliament's Treasury Committee. BOE Governor Andrew Bailey admitted that the Bank is facing its biggest inflationary test in 25 years and defended the BOE’s policy regarding soaring inflation rates in the UK.

The sterling has been losing ground against the dollar due to the divergence in monetary policy between the Fed and the BOE. Although the BOE started the year with a strong hawkish policy, it has recently backed down and moderated its stance, weighted down by the still fragile British economy. In contrast, the increasingly hawkish Fed policy is boosting the dollar against the pound.

In its latest monetary policy meeting, the Bank of England raised its benchmark interest rate by 25 base points, bringing its rate to a 13-year high of 1%. The BOE stressed once more the dangers of recession, as the economic contraction is battling with inflation rates that are predicted to surge to 40-year highs of 10% in the coming months. The cost of living in the UK has been increasing, driven primarily by the high cost of energy imports, putting pressure on UK households. Stagflation is a risk for the UK economy, as for many other countries, as economic stagnation coupled with rising inflation creates a toxic mix for the economy.

Brexit issues have come once again into the foreground after elections to the Northern Ireland Assembly. Last week, the EU rejected the latest UK proposal regarding the Northern Ireland protocol and the situation could trigger Article 16 of the Brexit deal, adding pressure to the pound. 

Minor economic indicators will be released for the UK on Friday, which is not expected to affect the currency significantly. In addition, MPC members are scheduled to deliver speeches on Friday, which may cause some volatility in the sterling. 

GBPUSD 1hr chart

TRADE GBP PAIRS

JPY

The Yen exhibited high volatility on Thursday, declining early in the day, but later its price rose considerably. The USD/JPY rate plummeted to the 127 level on Thursday after the Yen gained strength. If USD/JPY rises again, it may find resistance at 131.35 and further up at the 2002 high of 135.3. If the USD/JPY declines, support might be found near the 127 level and further down near the 121.3 level. 

The Yen gained strength on Thursday, on increased market risk-aversion sentiment. The currency has been oversold over the past few months and has begun gaining some traction. High-risk assets declined on Thursday, while the Yen attracted market attention as a safer investment. The dollar is also a safe-haven currency but has been trading in overbought territory and has been slipping this week. Declining US bond yields also contributed to the dollar’s weakness on Thursday. 

Annual Preliminary GDP Price Index and Quarterly Preliminary GDP data released this week for Japan exceeded expectations. GDP data remained negative but were better than expected. The economy in Japan continues to contract, but at a slower rate than expected, indicating that the Japanese economy is moving in a more positive direction. Annual PPI in Japan rose to 10% for April and was higher than expected, indicating that inflation rates are rising in Japan, mostly due to the rising costs of imported energy.

The Yen has been retreating for months, with market investor interest in the currency slowing down, despite global economic risks. The currency, which has been oversold, regained some of its lost ground at the end of last week, but the outlook for the USD/JPY pair remains bullish.

Bond yields fell across Japan’s treasury curve last week, giving weak results, due to low demand. Japan’s 10-year government bond yield auction last week maintained the 0.25% interest rate as the BOJ continues to buy an unlimited amount of Japanese treasury bonds, defending their current low yield.  In contrast, the respective US 10-year bond is offered with a yield of over 3%, more than an order of magnitude higher than the Japanese bond. The large divergence in bond yields makes the low-yielding Yen less appealing to investors than the dollar, pushing its price further down.

The primary driver of the Yen over the past few months has been the BOJ’s fiscal policy, with the BOJ following an ultra-easy monetary policy to support the struggling economy. While other countries are moving towards quantitative tightening to return to pre-pandemic fiscal policies, Japan continues to pour money into the economy and maintains its negative interest rate. The difference in interest rates with other major Central Banks, especially with the Fed, puts the Yen at a disadvantage, driving its price down.

USDJPY 1hr chart

TRADE JPY PAIRS

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Written by:
Myrsini Giannouli

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