EUR/USD dips below 1.1250 as risk appetite returns and traders up hawkish Fed bets

EUR/USD has been under pressure in recent trade as the market’s broader appetite for risk continued to pick up. The pair slipped below 1.1250 in recent trade and even managed to momentarily eclipse last Tuesday’s post-hawkish Fed Chair Jerome Powell testimony lows at 1.1235. At its current levels, EUR/USD is now trading lower by about 0.4% on the day, making the euro the joint-worst performing G10 currency on the day alongside the Swedish krona. The bears will likely be looking for a retest of recent annual lows under 1.1200 in the coming sessions.

Driving the day

Improving risk appetite has been the major driver of EUR/USD's downside move on Tuesday. Traders and analysts have been citing receding Omicron fears and Chinese stimulus hopes as driving the broad rebound in sentiment that saw the S&P 500 open 1.2% higher and the Stoxx 600 index trading nearly 2.0% higher on Tuesday. Market participants appear to be coming around to the idea that the Omicron variant causes milder symptoms than past Covid-19 variant, thus posing less of a threat to the economic outlook.

Expectations for Fed monetary policy tightening in 2022 have broadly returned to pre-Omicron levels. The implied yield on the December 2022 three-month eurodollar future rose back to 1.05% on Tuesday, up from under 1.0% at the start of the week and as low as 0.8% at the end of December. In the absence of any important US data releases or Fed speak (Fed members are in blackout ahead of next week’s meeting), this recent repricing has clearly been a function of improvement in the market’s broader risk appetite.

Central bank policy divergence remains the main theme driving EUR/USD in the medium-term. Another rise in US Consumer Price Inflation (CPI) numbers at the end of the week ought to solidify market expectations for the Fed to agree to accelerate the pace of their QE taper from January, which could further weigh on EUR/USD. Recent ECB-related newsflow is noteworthy, however.

Hawkish ECB member Robert Holzmann recently remarked that inflation will probably exceed the bank’s 2.0% target in 2022, well above the bank’s current forecast of inflation of 1.7% next year. Fellow hawk Madis Muller also raised similar concerns. Meanwhile, according to ECB sources, policymakers at the bank are second-guessing prior commitments made to ongoing stimulus amid higher-than-expected inflation. Regarding QE, some policymakers are reportedly reluctant to commit to anything beyond the end of Q2 2022. If it does emerge that the ECB is not going to increase the APP to make up for the end of the PEPP in March next year, as seems increasingly likely, this may support the euro against the low-yielding yen and Swiss franc, but probably not against USD, given that the Fed will, in any case, remain well ahead of the ECB in terms of monetary normalisation.