Euro climbs ahead of ECB interest rate decision

Important calendar events

• EUR: Main Refinancing Rate, Monetary Policy Statement, ECB Press Conference
• USD: Unemployment Claims, Natural Gas Storage, 30-y Bond Auction

USD

The dollar remained fairly steady on Wednesday, with the dollar index remaining mostly above 102.5. Bond yields also rose, with the US 10-year treasury note yielding above 3.0%.

US economic indicators released on Wednesday were mostly negative for the US economy, failing to provide support for the currency. The 10-year US bond auction, on the other hand, boosted the dollar, with the bond yielding 3.03% and a high bid-to-cover ratio.

Continued Russian hostilities against Ukraine have increased risk-aversion sentiment, 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, although risk appetite seems to be gradually returning to markets. 

US economic data and Fed rhetoric remain the primary drivers of the dollar. In its latest monetary policy meeting, the US Federal Reserve raised its benchmark interest rate by 50 base points to 1%. Fed rhetoric has become more cautious though, as inflation woes were balanced out by recession fears. FOMC members point to a series of rate hikes of 50 base points each, confirming that the Fed intends to move with a gradual but steady pace towards monetary policy normalization. 

Markets have already priced in a series of aggressive rate hikes this year, and the Fed’s more guarded stance recently is causing the dollar to slip. In the coming weeks, the USD price will be affected by US economic, employment, and inflation data, as these will likely determine the aggressiveness of the Fed’s monetary policy tightening. Fed member's speeches will also likely cause volatility in USD price, as market investors will scan these speeches to gauge the US Central Bank’s intentions.  

Economic indicators that are scheduled to be released on Thursday for the US include unemployment rates, which may cause some volatility in the currency.

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EUR 

The Euro gained strength against the dollar on Wednesday, ahead of the ECB interest rate decision on Thursday, with the EUR/USD rate climbing above 1.070. If the currency pair goes up, it may encounter resistance at 1.093. If the currency pair falls, it may encounter support at the 1.036 level that represents the 2016 low, and further down near a 20-year low of 0.985.

Economic data released on Wednesday for the Eurozone were mixed, with German Industrial Production, French Trade Balance, and Italian Retail Sales falling below expectations. Eurozone Final Employment Change and revised GDP on the other hand, were higher than expected, providing support for the currency. 

Last week, EU members announced a gradual ban on Russian oil imports. Concerns about rising energy costs in the EU that would bring inflation even higher up are putting pressure on the Euro.

Economic growth in the EU has been stalling after the pandemic, raising fears of a potential recession. Even though the ECB has pointed clearly to a shift towards a more hawkish policy, stagnating Eurozone economies limit the ECB’s flexibility to increase interest rates to combat high inflation. CPI estimates, which are leading indicators of consumer inflation, showed that EU inflation is on the rise. Inflation in the Eurozone climbed to record highs, reaching 8.1% in May, driven by rising food and energy costs.

The Euro has been regaining some of its lost ground against the dollar, as ECB and Fed policies seem to be converging gradually. The ECB has been hinting heavily at a July rate hike, while the Fed grows hesitant about moving forward with a more aggressive monetary policy. Rising inflation rates in the EU increase the chances that the ECB will go forward with a rate hike in July. 

Clear indications from the ECB that it would move towards a more hawkish policy this year, have boosted the Euro. 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. Markets are now pricing in up to 130 base points rate hikes throughout the year.

This week, all eyes are going to be on the ECB meeting on Thursday and the announcement of its main refinancing rate. Even though the EU Central Bank is not expected to change its benchmark interest rate at this meeting, the ensuing Monetary Policy Statement is going to be scanned closely by traders and will likely cause some volatility for the Euro. The ECB is not expected to raise its interest rate until July, although some market participants expect a rate hike on Thursday and markets are pricing in the possibility of a small, 10-base points rate hike this week. In case the ECP Policy Statement is more dovish than expected, the Euro may fall again.

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GBP 

The sterling retreated on Wednesday, as news of the British PM’s win in the vote of no-confidence against him deflated, and the GBP/USD rate fell to 1.252. If the GBP/USD rate goes up, it may encounter resistance near the 1.308 level, while if it declines, support may be found near the two-year low at 1.206. 

On Monday, the British PM Boris Johnson faced a vote of no-confidence from within his party after the threshold of 15% of the party voted against the UK PM. Boris Johnson won the vote by a margin of 211 to 148, but an unexpectantly large number of Tories voted against him and the political climate in the UK remains tense.

UK Construction PMI data released on Wednesday were lower than last month’s and slightly lower than expected, putting pressure on the currency. The UK 10-year bond yielded 2.3% at Wednesday’s auction and a relatively high bid-to-cover ratio, providing support for the currency.

Last week, UK economic data were weak, indicating that the economic outlook for the UK remains discouraging and that the British economy is still sluggish, raising fears of a possible recession. Headline inflation in the UK 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. 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. 

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 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%. 

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JPY

The Yen continued falling against the dollar on Wednesday, with the USD/JPY pair trading above the 131.3 resistance level representing March’s peak and climbing as high as 133.0. If USD/JPY rises, it may find resistance at the 2002 high of 135.3. If the USD/JPY declines, support might be found near the 127 level and further down at the 121.3 level. 

Several financial indicators were released on Wednesday for Japan, such as Bank Lending, Current Account, Final GDP Price Index, Final GDP, and Economy Watchers Sentiment. Overall, the data released on Wednesday were mixed, indicating that the Japanese economy is still struggling to recover from the effects of the pandemic. 

The dollar’s recovery this week is making the Yen less appealing to investors as the two currencies are competing as safe-haven assets. The Yen has been losing its status as a safe-haven currency, however, and has been retreating since the beginning of the year.

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.

On Monday, BOJ Governor Haruhiko Kuroda stated that the Bank’s primary focus was to support the Japanese economy which is still struggling from the impact of the pandemic, and remained emphatically against a monetary policy tightening. Kuroda stressed that the BOJ’s accommodative policy is set to continue, despite Japan’s CPI breaching the BOJ’s 2% target, reaching 2.1% for the first time in seven years. Kuroda stated that Japan’s rising inflation rates are temporary and are mainly due to commodity and energy price rises rather than the result of a growing economy. In addition, Kuroda spoke in favor of a weak Yen although the combination of a weak currency and rising inflation is burdening Japanese households.

Bond yields have fallen across Japan’s treasury curve due to low demand. Japan’s 10-year government bond yielded a 0.24% interest rate at the bond auction on Thursday with a low number of bids made per bid accepted. 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 approximately 2.8%, 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.

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Written by:
Myrsini Giannouli

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