The recovery rally in EUR has become one of the key market themes of the new year. On the back of the roughly 17% loss in EURUSD across 2022, the pair has since recovered around 75% of these losses since Q4 last year.
Across the G10 space, EUR is seeing solid gains as we start the second month of the year and traders are now questioning whether the current rally has further to go or if gains are likely to fizzle out and see a resumption of the weakness we saw over most of last year. With that in mind, let’s take a look at the factors driving the current EUR rally and how they look set to continue moving forward.
Fed pivot & USD reversal
One of the main drivers behind the move higher in EUR has been the reversal in USD. The rally in USD over much of last year saw EUR turn sharply lower. With the market chasing an increasingly hawkish Fed, USD saw a surge of demand across much of the year. However, into late Q3, these gains started to fade as traders began anticipating a shift in monetary policy from the Fed.
Divergence between ECB & Fed
The Fed finally stepped down the pace of its rate hikes in December, further encouraging a shift in expectations among traders with USD downside accelerating consequently. This shift in positioning saw a flood of capital into EUR as traders reacted to the ECB’s message of further tightening. With the ECB late to begin tightening and essentially playing catch up with the other main G10 central banks, there was a divergence in the outlook for the ECB and Fed (ECB to keep tightening aggressively, Fed to scale back tightening) which further favoured higher EUR prices.
At the start of this year, this dynamic has been further reinforced by outright hawkishness from the ECB. The Fed was seen pivoting further on rates at the February FOMC, hiking by just 25bps, down from the 50bps hike in December and the 75bps hike seen prior. Furthermore, Fed chairman Powell noting that the disinflation process has begun in the US has since seen the market adjusting its US rate expectations lower over coming months.
Hawkish ECB signals
This message is in stark contrast to the ECB with president Lagarde warning in January that inflation remained way too high and as a result, further tightening would be needed. Lagarde signalled that the ECB intended to keep going on rates until inflation is back down at the bank’s 2% target zone.
February ECB hike & outlook
At the February ECB meeting, the bank hiked rates by a further 50bps and signalled a further 50bos hike to come in March. After March, the ECB noted that further monetary policy adjustments will be data dependent and decided meeting by meeting. However, the ECB was keen to stress that March will not mark the pinnacle of its tightening program. The ECB has been forthright in stating its focus on driving inflation down and as such the key factor to watch is CPI over the coming months. If inflation starts to cool more quickly this will increase the chances of the ECB pivoting on rates beyond the March meeting which will likely limit EUR upside into Q2.
Near-term outlook
Looking ahead, the ECB notes that the eurozone economy is beginning to pick up. The sharp drop in energy prices has been a firmly positive factor and with energy prices expected to fall further in the coming months, energy inflation is expected to reduce further. However, food prices and non-energy inflation remain firm and look likely to remain so for some time. With this in mind, the ECB forecasts that it will keep restrictive rates in place until such time that inflation is brought under control.
EURUSD - weekly chart
Source: TradingView / FlowBank
The rally in EURUSD off the Q3 lows has seen the pair breaking above the bear channel from 2021 highs. Price has also now broken above the 1.0703 level (the broken 2020 lows). While the market holds above here, the outlook remains bullish with a continued rally towards the 1.1205 level the preferred view.
