- A hawkish Federal Reserve and a dovish European Central Bank put pressure on EUR/USD.
- US President-elect Donald Trump’s policies set to overshadow macroeconomic releases.
- EUR/USD set to pierce the year low at 1.0177 and test parity in the upcoming days.
United States (US) Donald Trump’s Inauguration Day is around the corner. Trump will become the 47th president on Monday, assuming the US presidency for the second time.
The US Dollar (USD) trades near fresh multi-year highs against most major rivals, and the EUR/USD pair heads into the event trading at around 1.0300, after hitting 1.0177 earlier in the week.
Trump policies and the Federal Reserve
Speculative interest anticipates Trump's policies will force the Federal Reserve (Fed) to adopt a hawkish stance. But it is not just about how Trump could affect the Fed, markets are also considering where the economy is heading for the next four years.
The main subject is tariffs. Trump pledged to impose massive tariffs on Chinese products, but also on goods coming from neighbour countries such as Mexico and Canada. He claims these measures will generate additional jobs and reduce the federal deficit. Could be true. But it’s also true that such measures will also boost the USD and, thus, could increase the risk of global financial instability while also posing a risk to local inflation and, hence, affecting the Fed’s monetary policy decisions.
In fact, the Fed anticipated in its final 2024 meeting that it will likely reduce the pace of interest rate cuts throughout 2025. “All participants judged that uncertainty about the scope, timing, and economic effects of potential changes in policies affecting foreign trade and immigration was elevated,” the December Federal Open Market Committee (FOMC) minutes said.
Meanwhile, the US economy is in much better shape than its major counterparts. Growth has been picking up, while the job market remains strong. Inflation seems to have stabilised just above the Fed’s 2% goal.
Trump’s government will have multiple consequences on the US and global economy. “May you live in interesting times,” says the Chinese curse. Indeed, interesting times lay ahead.
One thing is sure. Markets never lose hope. The US published last Tuesday softer-than-anticipated Producer Price Index (PPI) figures, while on Wednesday the country released the Consumer Price Index (CPI) for the same month. The annual CPI rose by 2.9%, as expected, yet the core annual figure posted a modest contraction, printing at 3.2% from 3.3% in November. As a result, investors rushed to price in higher interest rate cuts in May. The odds, however, are actually lower than bets.
Dovish European Central Bank
Meanwhile, European Central Bank (ECB) officials maintained a dovish tone. Vice-President Luis de Guindos noted that the disinflation process in the Eurozone is progressing favourably in the short term, yet added that US trade policies may affect the outlook.
Furthermore, the ECB Accounts of the December meeting showed that some policymakers considered a 50 basis points (bps) interest rate cut but opted for a gradual dial-back of policy restrictiveness. Finally, the document reads: “Geopolitical and economic policy uncertainty had become more pronounced since the last Governing Council meeting.”
Finally, tepid European macroeconomic figures indicate the most sluggish progress in the Old Continent.
So, on one hand, we have a strong US economy coupled with a hawkish Fed. On the other hand, a dovish ECB coincides with tepid European economic progress. At this point, a EUR/USD slide below parity seems inevitable.
Macroeconomic imbalances favor the USD
Data-wise, the upcoming week will bring some relevant headlines. Germany will release the ZEW Survey on economic sentiment on Tuesday. The Hamburg Commercial Bank (HCOB) will release the preliminary estimates of the January Purchasing Managers’ Indexes (PMIs) for the Eurozone, while S&P Global will unveil US indexes on Friday.
Still, whatever Trump decides in the first days of its government will likely overshadow data. Markets may have a clear sign on whether tariffs will be massively or cautiously imposed. Tariffs are coming anyway.
EUR/USD technical outlook
The weekly chart for the EUR/USD pair shows it is closing the week with modest gains yet below the 1.0300 threshold. The same chart shows that the pair has posted a lower low and a lower high, in line with the dominant bearish trend. Even further, the pair develops well below all its moving averages, with the 20 Simple Moving Average (SMA) accelerating south below directionless 100 and 200 SMAs. Finally, technical indicators have bounced from their lows but remain near oversold readings. Indicators reflect the ongoing bounce but are short of suggesting additional gains ahead.
Technical readings in the daily chart skew the risk to the downside. A bearish 20 SMA provides dynamic resistance at around 1.0340, while the 100 SMA aims south at around 1.0750 after crossing below the 200 SMA. Technical indicators, in the meantime, consolidate within negative levels, lacking clear directional strength.
Gains beyond the aforementioned 1.0340 region could see the pair correcting towards the 1.0430 region, where the pair topped this month. Gains beyond the latter seem unlikely, yet the next relevant resistance level is the 1.0500 threshold. Support, on the other hand, comes at 1.0260, where EUR/USD met buyers in the last three trading days, ahead of the yearly low set at 1.0177. Once below the latter, the 1.0100 mark comes next, en route to parity and beyond.
Central banks FAQs
Central Banks have a key mandate which is making sure that there is price stability in a country or region. Economies are constantly facing inflation or deflation when prices for certain goods and services are fluctuating. Constant rising prices for the same goods means inflation, constant lowered prices for the same goods means deflation. It is the task of the central bank to keep the demand in line by tweaking its policy rate. For the biggest central banks like the US Federal Reserve (Fed), the European Central Bank (ECB) or the Bank of England (BoE), the mandate is to keep inflation close to 2%.
A central bank has one important tool at its disposal to get inflation higher or lower, and that is by tweaking its benchmark policy rate, commonly known as interest rate. On pre-communicated moments, the central bank will issue a statement with its policy rate and provide additional reasoning on why it is either remaining or changing (cutting or hiking) it. Local banks will adjust their savings and lending rates accordingly, which in turn will make it either harder or easier for people to earn on their savings or for companies to take out loans and make investments in their businesses. When the central bank hikes interest rates substantially, this is called monetary tightening. When it is cutting its benchmark rate, it is called monetary easing.
A central bank is often politically independent. Members of the central bank policy board are passing through a series of panels and hearings before being appointed to a policy board seat. Each member in that board often has a certain conviction on how the central bank should control inflation and the subsequent monetary policy. Members that want a very loose monetary policy, with low rates and cheap lending, to boost the economy substantially while being content to see inflation slightly above 2%, are called ‘doves’. Members that rather want to see higher rates to reward savings and want to keep a lit on inflation at all time are called ‘hawks’ and will not rest until inflation is at or just below 2%.
Normally, there is a chairman or president who leads each meeting, needs to create a consensus between the hawks or doves and has his or her final say when it would come down to a vote split to avoid a 50-50 tie on whether the current policy should be adjusted. The chairman will deliver speeches which often can be followed live, where the current monetary stance and outlook is being communicated. A central bank will try to push forward its monetary policy without triggering violent swings in rates, equities, or its currency. All members of the central bank will channel their stance toward the markets in advance of a policy meeting event. A few days before a policy meeting takes place until the new policy has been communicated, members are forbidden to talk publicly. This is called the blackout period.
US Dollar FAQs
The US Dollar (USD) is the official currency of the United States of America, and the ‘de facto’ currency of a significant number of other countries where it is found in circulation alongside local notes. It is the most heavily traded currency in the world, accounting for over 88% of all global foreign exchange turnover, or an average of $6.6 trillion in transactions per day, according to data from 2022. Following the second world war, the USD took over from the British Pound as the world’s reserve currency. For most of its history, the US Dollar was backed by Gold, until the Bretton Woods Agreement in 1971 when the Gold Standard went away.
The most important single factor impacting on the value of the US Dollar is monetary policy, which is shaped by the Federal Reserve (Fed). The Fed has two mandates: to achieve price stability (control inflation) and foster full employment. Its primary tool to achieve these two goals is by adjusting interest rates. When prices are rising too quickly and inflation is above the Fed’s 2% target, the Fed will raise rates, which helps the USD value. When inflation falls below 2% or the Unemployment Rate is too high, the Fed may lower interest rates, which weighs on the Greenback.
In extreme situations, the Federal Reserve can also print more Dollars and enact quantitative easing (QE). QE is the process by which the Fed substantially increases the flow of credit in a stuck financial system. It is a non-standard policy measure used when credit has dried up because banks will not lend to each other (out of the fear of counterparty default). It is a last resort when simply lowering interest rates is unlikely to achieve the necessary result. It was the Fed’s weapon of choice to combat the credit crunch that occurred during the Great Financial Crisis in 2008. It involves the Fed printing more Dollars and using them to buy US government bonds predominantly from financial institutions. QE usually leads to a weaker US Dollar.
Quantitative tightening (QT) is the reverse process whereby the Federal Reserve stops buying bonds from financial institutions and does not reinvest the principal from the bonds it holds maturing in new purchases. It is usually positive for the US Dollar.
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