Central banks are facing a tough choice, whether to raise the rates aggressively and curb inflation or tighten monetary policy slowly, averting the recession. The ECB faces a tougher choice, it must save the euro too. Let us discuss the Forex outlook and make up a EURUSD trading plan.
Weekly euro fundamental forecast
What is more dangerous, the illness or the treatment? Reacting to the rise of European inflation to record highs and the euro drop, the ECB turned on hawkish rhetoric and embarked on the path of raising rates. As a result, the nominal yield spread of 10-year US and German bonds has decreased by 0.3% since the beginning of May and by 0.7% in real yield. The EURUSD has been down to a five-year low. The problem is that the tightening of monetary policy leads to an increase in borrowing costs, and Italy, Greece, and other euro-area member states that have huge debts will have problems.
Investors are concerned about the ECB’s upcoming meeting on June 9. Inflation exceeds 8%, and the embargo on Russian oil is sure to raise it even higher. Monetary tightening is a must, but any medal has a reverse. The growth of interest rates is fraught not only with a slowdown in the euro-area GDP and stagflation but also with the eurozone break-up. The latter threatens the very existence of the euro. On expectations of the QE end, the yield spread for Italian and German bonds, a key indicator of political risk in the euro area, has widened from 140 basis points in January to more than 200 basis points, the highest level since the pandemic started.
Whereas Governing Council members previously believed that reinvesting the proceeds from maturing debt would be sufficient to close the spreads, they are now unsure of this. Some analysts expect the ECB to announce a new QE programme at the June meeting to calm the euro-area bond markets.
On the other hand, the expectations of the ECB’s aggressive rate hike give a reason to buy the EURUSD. In May, hedge funds built up euro net longs at the second monthly rate in almost two years, bringing them to a 12-week high. Moreover, over the past couple of weeks, speculators have increased their euro net long positions by $5 billion, which is equivalent to the losses of the US dollar against G10 currencies over the same period.
Barclays believes that the ECB will raise the deposit rate by 25 basis points at each meeting from July to December and, in the first quarter of 2023, will bring it to 0.75%. Bank of America’s forecast is much more aggressive, expecting +150 bps in 2022, including +50 bps in July and September. According to the bank, this is the minimum that Christine Lagarde and her fellow central bankers should do in the face of the euro-area inflation accelerating to 8.1%. The derivatives market expects a 130-basis-point increase in borrowing costs, including a 50 bps increase at one of the Governing Council meetings until October.
Weekly EURUSD trading plan
Thus, the ECB should start the treatment, monetary tightening. However, it must consider the side effects, such as a slowdown in GDP and higher risks of the euro-area break-up. The European Central Bank faces a tough choice. Furthermore, the drop in the US stock indexes and Treasury yield rise could encourage the EURUSD bears. However, if the price goes above 1.068, it could enter a short-term consolidation in the range of 1.068-1.075.