EUR/USD analysis: Has the ECB lost its grip on Eurozone inflation?
13:02, 31 October 2022
The eurozone's inflation rate keeps rising and outpacing analysts' forecasts. In October, the annual inflation rate in the Euro Area continued to set new records, rising to 10.7% from 9.9% in September and against expectations of 10.2%.
Energy prices continue to be the main contributor to the increase (up 41.9% versus 40.7% in September), followed by food, alcohol, and tobacco prices (13.1% vs 11.8%). However, annual inflation excluding energy and food also surged to a new all-time high of 5%, up from 4.8% in September and against a 4.9% forecast.
These figures came just a few days after the October ECB meeting, which gave the second straight 75bps hike while also indicating a meeting-by-meeting strategy without pre-commitments on future moves.
The market saw the ECB’s tone as more dovish than expected, causing speculators to lower Eurozone rate pricing to 2.5% in 2023 from 3% before the meeting. Following the ECB meeting, the euro (EUR/USD) lost roughly 1% and fell below parity once more.
The latest Eurozone inflation statistics, together with third-quarter GDP that was in line with expectations (0.2% qoq and 2.1% y/y), are expected to add to the uncertainty regarding the fate of rates and the performance of the euro going forward.
In the face of double-digit and rising inflation in the Eurozone, the ECB's dovish attitude might exert significant downward pressure on the euro. This might be further exacerbated if the Fed maintains its aggressive stance at this week's FOMC.
Could the euro fall to $0.95 or below in the upcoming weeks?
Can the ECB truly bring double-digit inflation down to 2%?
I believe the ECB will face significant challenges in bringing inflation back under control in the Eurozone in the foreseeable future.
Beyond the still very severe price pressures on items like energy and food, core inflation, which excludes these two components, continues to increase by 5% annually and 0.6% monthly.
These figures are in sharp contrast with the current interest rate level of 2% and the market pricing of 2.8% in September 2023.
Although it is difficult to imagine that rates of 2.8% or even 3% in 2023 will be enough to keep inflation at bay, the ECB is currently in a precarious situation to be hawkish given the impending Euro Area recession.
Raising rates too aggressively would worsen economic challenges for companies and households, but there is a price to pay by the ECB for taking such a tolerant attitude. This will include tolerating inflation that is structurally higher than the 2% target and may persist for a longer length of time, as well as suffering further currency depreciation.
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EUR/USD analysis: Bearish pressures from yield differentials resume
A hawkish FOMC meeting this week could cause the euro to lose more ground after it struggled to remain above parity against the dollar the previous week.
As the trend of divergence in short-term rates between the US and Europe does not appear to have been completely reversed, sellers' pressure has returned.
The yield differential between a 2-year US Treasury and a 2-year German Schatz has been pushing higher in recent days, around 2.56%, and may shortly test the October high of 2.6% before continuing its upward trend toward the 2.7%–2.8% range established in August.
Rising Fed-ECB rate differential in the coming weeks could lead to additional euro losses against the dollar.
EUR/USD technical analysis: Key levels to watch
The October's EUR/USD rally up to 1.009 levels, which resulted in the breach of the bearish trendline from 2022 and the 55-day moving average, was short-lived. The price action is already turning down, and EUR/USD could close in the red for the third session in a row.
A Fibonacci analysis of the price range between late September and late October may assist in determining the next EUR/USD target levels to monitor.
Prices are testing 0.9884 (the 38.2% Fibonacci retracement level) at the time of writing. If EUR/USD breaks below this level, the focus will shift to 0.981 (50% Fibonacci retracement).
This is an important level where EUR/USD could trade before Wednesday's FOMC meeting. A drop below 0.98 caused by a hawkish Fed will definitely kill the bulls' hopes and propel the EUR/USD considerably lower towards 0.9661 (78.6% Fibonacci).
In addition to a hawkish Fed, strong US data (NFP on Friday) and higher-than-expected US inflation on November 10th may be required for the EUR/USD to test and eventually break through the 2022 lows at 0.954, as these events may cause the market to significantly reprice US future hikes.