EUR/USD Cautious at Key Tech Junction, as ECB & US Inflation Loom

EUR/USD Analysis

The European Central Bank had hinted at peak rates in September ^[1], opening the door for a hold at Thursday's upcoming pivotal decision. If policymakers opt to stay on the sidelines indeed, it would be the first pause after ten consecutive hikes worth 450 basis points. The European economy is in a bad shape as indicated by a series poor PMIs and GDP figures, with Germany – its main engine – expected to contract by 0.5% this year, according to the International Monetary Fund ^[2]. This creates apprehension around further tightening and the latest inflation figures showed substantial deceleration. However, it is far from the 2% target and Ms Lagarde had kept the door open to more hikes.

The US Fed on the other hand, has maintained a more aggressive stance, despite having slowed the pace of tightening this year, as the labor market and the economy are strong. In September, officials kept their 5.6% median terminal rate forecast that implies one more hike this year and projected fewer 2024 rate increases than previously expected. Over the past couple of weeks though, some Fed voters have diverged from this messaging, with dovish remarks. Chair Powell did not sound particularly hawkish on Thursday, right before the communication black out period, but kept the door open to more hikes, saying that policy is not too tight. ^[3]

EUR/USD dropped in the third quarter as the Euro's rate advantage begun to erode, in a trend that culminated to the September policy decisions by the Fed and the ECB, which marked the reversal of the previously favorable monetary policy dynamics. Despite the recent rebound, the path of least resistance remains lower and the pair is vulnerable to new 2023 lows (1.0448), although sustained weakness past 1.0337 has higher degree of difficulty.

On the other hand, the recent soft remarks by Fed officials cast some doubts over their determination to go higher, while ECB policymakers may have a hard time staying on the sidelines given the still high inflation, which could persist given the Middle East conflict and its impact on oil prices. Furthermore, the USDOLLAR was unable to benefit from last week risk aversion and the rise in long-term bond yields, with the 10-year yield hitting 5% for the first time since 2007.

This is a sign that the greenback's strength may be reaching its limits and EUR/USD posted gains last week. It still tries to take out the critical 1.0625-42 resistance that can propel it to the next roadblock at 1.0750-63. However, the upside looks unfriendly and a strong catalyst would be needed for a more meaningful recovery.

Markets now turn to Thursday's pivotal decision by the ECB and Friday's US PCE inflation update for the next leg of the move, in an event-packed week that starts with tomorrow's preliminary PMIs.