The EURUSD downside risk isn’t over yet, what could trigger a EUR sell off?

Downside risk of EURUSD aren't over just yet, this past weeks pullback has made the test of parity much more challenging than it has been I recent weeks and may also help common currency withstand new solid US economic data.

The Fundamentals

Investors are still debating about the different intensity of policy normalization among major central banks and this is adding nervousness in financial markets, particularly in equities. The link between US stocks and the USD across the board (as measured by the dollar index, DXY) seems to have become asymmetric too.

Rising risk aversion and equity market weakness are generally positive for the greenback, as they reinforce its role as a favored safe-haven currency, while for the same reason more risk appetite and rallying stocks tend to weigh on the US unit.

This time, however, the USD has fallen along with US stocks (Chart 1), as concerns about US economic growth intensify and doubts about the size of Fed’s tightening going forward have also increased (the 10Y UST yield is now around 2.75% after hitting 3.12% on 6 May). As a result, the DXY dipped below 102 after testing 105 just a couple of weeks ago with an o ver-3% drop and the JPY has also outperformed the USD, dragging the USD-JPY down to the edge of 126.

A sort of repricing in interest rate expectations has probably played a central role in the USD fall and the EUR recovery. Atlanta Fed President Raphael Bostic, while backing a 50bp rate hike in both June and July, has already hinted at a possible pause in September.

On the other hand, the ECB has confirmed its current hawkish rhetoric by signaling that rates might exit negative territory by the end of 3Q22. Rates implied by the eurozone OIS curves have thus moved further up, while the US OIS curve has drifted lower since 13 May, when EUR-USD hit its YTD low of 1.0348 and the DXY touched its YTD high of 105.01 (Chart 2). Whether or not these additional hawkish tones from the ECB were aimed to help the euro, EUR-USD has pulled back to 1.0760. The extent of the EUR-USD rebound is significant. Looking at the charts, if 1.08 is also exceeded, the pair will have fully reversed the previous fall towards 1.03. Hence, calling for a turnaround in EUR-USD sentiment at this early stage would be tempting, but we prefer to remain prudent.

EUR Rally could be short lived

We do not think that EUR-USD downside potential is over yet. The rally has been fast and might now lead to further profit-taking, markets might be exposed to further volatility given the current uncertain global picture and interest rate differentials remain in the USD’s favor and might thus act as a brake on more momentum in the EUR-USD rally.

Geopolitical risks, starting with the Ukraine conflict, have not eased enough yet to call a full return of risk appetite. What seems to be much more feasible is that the EUR-USD rise has made at least a test of parity or below more difficult than it has been in recent weeks (the implied probability of such an event over a three-month horizon is now less than 10%, according to options deltas).

Weekly data on market positioning also reveal that on 20 May investors were net long EUR-USD for the second week in a row after starting May with net-short exposure, suggesting more interest in the EU currency. EUR-USD is now in a better position to face the series of US data that will be released in the coming days, including the jobs report, which is likely to be strong again. The focus in the eurozone will be on CPI inflation data. Another acceleration in price pressure, which we expect, will likely help the euro hold this week’s gains and further increase the cushion to the downside.

Technicals

On the technical side of things, EURUSD has a strong level of resistance at 1.08540 which could be the next stalling point for the currency. Our best bet would be to look for short positions around this level for a sell-off back to 1.04300 or so.

Get daily reports directly from Institutions

Want more daily market reports directly from large Institutions themselves? Sign up for our 7-day free trial. You will receive 10-20 reports each day directly from Institutions such as Goldman Sachs, Credit Suisse, Westpac, ING, Credit Agricole, and more! Click here

Looking for a trustworthy broker?

When we say we want to lower the price that people pay to trade forex, we mean it. That’s why we offer a commission rate that is on average 36% cheaper* than our closest competitors. Most brokers charge $5-$10 per trade for US Share CFDs. True to our mission, we’re charging $0 brokerage fees.

Check out Fusion markets! Click Here