18.01.202223:22 Forex Analysis & Reviews: EUR/USD: abnormal dollar and toxic euro

For most of the past year, the USD has been following an upward trend, playing off the prospect of tightening monetary policy in the United States.

Over the past 12 months, the single currency has fallen in price against the greenback by almost 6%.

Fans of the greenback hoped that these trends would continue in the new year.

Inflation in the United States reached a 40-year peak of 7%, the hawkish statements of the Federal Reserve representatives indicating an interest rate hike in March and quantitative tightening this year, as well as a sharp retreat of US stock indexes from record highs, seemed to serve as a springboard for a strong start to the year and further USD growth.

However, instead, the dollar sank to a two-month low, declining against a basket of major currencies by 0.8% last week. This allowed the EUR/USD pair to break out of the six-month bearish trend.

The incident caused confusion among many market participants, since the fundamental picture, at first glance, has not changed dramatically.

Apparently, too much positive news has already been taken into account in the USD exchange rate.

The abnormal behavior of the US currency is also explained by the early reaction of investors to the fact that the dollar historically reaches its peak around the time when the Fed raises interest rates.

Some traders began to put in quotes a scenario according to which the pandemic is nearing its end.

The recent rebound of the EUR/USD pair is a reflection of expectations that the eurozone economy, compared to the US economy, has a greater potential for a post-pandemic recovery in terms of the service sector.

In addition, investors are already moving beyond the Fed's rate hike path in search of signs that other central banks will soon begin to tighten their policies.

Until last week, even the suggestion that the European Central Bank might start raising rates this year was fantastic. However, at present, the futures market is pricing in a 20 basis point rate hike in the eurozone by December 2022.

"As long as the difference in interest rates does not change significantly in favor of the dollar, it will be difficult for it to continue its rally, especially in the current conditions, when yields outside the United States are also gradually growing, both in Germany and Japan," UniCredit analysts noted.

In order for the USD to turn around quickly, as hedge funds and most analysts expect, the Fed may have to send an even more aggressive signal from its next monetary policy meeting, which will be held on January 25-26.

The US currency often strengthens before the start of the Fed's tightening cycle, and then weakens as soon as it begins. While the central bank won't change policy later this month, it will likely clear the way for a March launch and provide more details on when and how it will begin to reduce its balance sheet.

Having forced the market to lean towards four rate hikes and quantitative tightening this year, the US central bank may have to back up the rhetoric with actions.

"Recent events have shown that market expectations of the Fed's actions have reached the highest possible level in recent times. The dollar weakened sharply after the release of the December CPI in the United States. This is a sign that it is difficult for the market to shift the level of the Fed's "terminal" rate for the upcoming cycle beyond the 2.0% area," Saxo Bank strategists said.

Speculators' net long positions on the US currency, or bets that the greenback will rise, decreased in the week before January 11, but they remained close to recent highs. This suggests that investors are trying to hold the dollar against the background of the hawkish rhetoric of the Fed in recent months, Rabobank analysts say.

"However, the USD sell-off on the spot market last week indicates that long positions on the US currency have become crowded," they said.

At the end of last year, the dollar looked overbought, but the fall of the USD index below 95 points and the growth of the EUR/USD pair in the area of 1.1500, it seems, eliminated the technical overbought of the US currency.

At the same time, the recovery of EUR/USD from the 2021 low was quite an expected correction, since the end of May, when the euro formed a peak at $1.2266, the pair has mainly been in a bearish trend.

Having reached a two-month low in the area of 94.60 points last Friday, the greenback returned to positive territory.

After the EUR/USD pair approached the Fibo level of 61.8% of the decline correction from 1.1690 to 1.1185, the interest in it from bulls weakened.

Touching the highest marks since November last year in the area of 1.1480, the main currency pair rolled back.

The markets started the new week calmly. The activity of traders was low due to the celebration of Martin Luther King Day in the United States. The dollar strengthened moderately the day before against its main competitors. According to the results of Monday's trading, the euro fell in price against the greenback by almost 0.1%. At the same time, the EUR/USD pair spent most of yesterday in the range of 1.1395-1.1430.

The greenback maintained a bullish momentum on Tuesday, rising above 95.70 points.

Meanwhile, the main currency pair continued to decline, sinking to a weekly low around 1.1330.

Even positive statistical data on the eurozone, which exceeded forecasts, could not support the single currency.

According to ZEW, the index of economic expectations in the currency bloc in January rose to 49.4 points compared with 26.8 points recorded in December, and against a preliminary estimate of 29.2 points.

The dollar went on an active offensive against its main rivals against the backdrop of rising yields on US Treasury bonds.

On Tuesday, the indicator for 10-year treasuries reached the highest level in two years at about 1.85%.

According to market participants, such a jump may be associated with increased hopes that the Fed is able to tighten monetary policy even more actively in 2022 – for example, it will raise the key rate by 50 basis points in March at once. In particular, such thoughts of investors could be prompted by the hawkish comments of FOMC members made on Friday before the start of the so-called "period of silence".

ING strategists are keeping EUR/USD targets around 1.08/1.10 this spring/summer as the Fed tightens its cycle and treasury yields rise on expectations that the US central bank will quickly begin to reduce its balance sheet. They continue to consider short positions in the euro against the dollar attractive.

The National Bank of Canada believes that in the coming year the single currency will again not show impressive results.

"The European Central Bank remains cautious, while the Fed and other key central banks of the world begin to normalize policy. The inaction of the ECB may lead to a weakening of the euro, which will result in an increase in imported inflation," bank analysts said.

"We expect the strengthening of the euro to be contained in 2022. The eurozone will have to deal with supply chain problems and inflationary pressures, while the ECB is unlikely to signal significant changes in monetary policy before the end of this year," they added.

The EUR/USD pair is down for the third day in a row and is trading below 1.1385 (38.2% retracement of the bearish move at 1.1690-1.1185).

After losing support around 1.1340, the pair could target 1.1300 and 1.1260.

On the other hand, resistance is located at 1.1390, and further - at 1.1430 and 1.1470.