Dollar weakness leads to gains for EUR and GBP, but has the market turned bearish on USD too soon?

EUR/USD

The week was defined by dollar weakness and euro strength: EUR/USD broke through key resistance at $1.21 as a combination of central bank communication and geopolitical developments boosted sentiment. 

The pair breached the September high at $1.2092 to give it clear breathing space before any further resistance and now bulls are targeting $1.26 as the 61.80% round number retracement of the move from the $1.40 2014 peaks to the lows at $1.03. By Friday EUR/USD seemed to be pausing for breath a little shy of the 50% retracement around $1.2165 before a strong US core CPI print on Friday afternoon saw a slight pullback in EUR/USD, although longer-term momentum does still appear with EUR for now.

Let’s first look at the reasons for this new bout of Euro strength. Firstly, ECB policy meeting minutes were bullish, although the hawks could be disappointed when the governing council convenes next. The potential to disappoint remain high and we note that the ECB has a track record of moving more slowly than FX markets think. Inflation – especially core inflation – remains muted.

Of particular note, the ECB suggested that language on forward guidance could be changed early this year. This ought not to be a big surprise, given the pace of recovery we have seen and time horizon for the QE programme, but it has nevertheless given euro bulls a reason to be more confident. It did suggest the governing council is singing from the same hymn sheet, which wasn’t necessarily the case in October. It also indicated that the ECB is a little less worried about EUR appreciation for now.

‘The language pertaining to various dimensions of the monetary policy stance and forward guidance could be revisited early in the coming year,’ the minutes said.

The implication is the ECB could be willing to be a little more precise on when it expects to be able to raise interest rates and is more confident in the recovery sustaining momentum. Currently the guidance states that the key ECB interest rates will remain at their present levels ‘for an extended period of time, and well past the horizon of the net asset purchases’.

That is not to say it is planning to pursue a swifter route to normalisation of policy; and indeed the minutes state the forward guidance framework would ‘evolve naturally, in line with the established sequencing between the APP and interest rate guidance’.

Furthermore, the ECB warned that ‘signals that could trigger an unwarranted tightening of financial conditions needed to be avoided, as they could jeopardise progress towards the Governing Council’s inflation aim’.

Building on the ECB minutes, Germany finally broke the political deadlock on progress towards forming a coalition, removing another hurdle for euro bulls. On the political risk front, it’s worth stressing however that Italian elections this year could be a lot more meaningful.

DXY

The dollar index was trading at its weakest since late 2014 - Federal Reserve rate hikes have done nothing to boost the dollar since the central bank began tightening (as explored previously this is a symptom of FX markets moving light years ahead of central banks). But could USD weakness be overblown?

The Fed remains on track to raise rates at least three times this year, US growth is strong and tax reform has finally been passed. All of this supports a more bullish case on USD than the price action over the last week suggests. Market indicators suggest only a 67% the Fed will raise rates in March, with CME’s Fed Watch tool showing only a 50% chance policymakers will follow through on 3 hikes in 2018.

US data on Friday proved something of a bulwark for USD and appeared to put a ceiling on EUR gains for the time being with a decent core CPI figure – the best since Jan 2017 - boosting expectations for short term rates – before the release the chances the Fed would hike in March were at little over 60%. US 2-year yields leapt above 2% and 10s rose back above 2.58% as the continued their volatile week following the ‘fake news’ on China’s appetite for Treasury notes. All told the data lends further support for US Dollar bulls that conditions favour more rather than fewer Fed hikes this year, yet momentum appears against them.

GBPUSD

Dollar weakness lifted sterling as the cable continued its year-long uptrend. With 1.36 breached, the next target for bulls was the September high of $1.36574, which was duly taken out following reports that Spain and the Netherlands will work toward a ‘soft’ Brexit deal, with GBPUSD making a stab at $1.37 before pulling back to trade around the $1.3670 level.

Having breached the 50% retracement from the move from $1.50 before the Brexit referendum to the low of below $1.20 in January 2017, the next take-out for long-term bulls is the 61.8% retracement around $1.38585. However we’ve been here twice before in recent months and GBP remains uniquely sensitive to the Brexit process. Moreover there is little evidence that the Bank of England is ready to turn any more hawkish as inflation is expected to cool over the coming months.

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