01.07.202214:25 Forex Analysis & Reviews: EUR/USD: euro to come under pressure from recession, weak ECB position

This week, policymakers from the European Central Bank, the Bank of England, and the Federal Reserve met at the ECB Forum on Central Banking in Sintra, Portugal to discuss monetary policy scenarios.

Statements by heads of US, EU, and UK central banks signalled their plans on interest rates.

According to these statements, neither Christine Lagarde nor Andrew Bailey will be able to match the hawkish position of Jerome Powell in the near future. Out of all central banks, the Fed came closest to meeting current market expectations.

Key statements

"We're strongly committed to using our tools to get inflation to come down. The way to do that is to slow down growth, ideally keeping it positive," Jerome Powell said. "Is there a risk that would go too far? Certainly, there's a risk. I wouldn't agree that it's the biggest risk to the economy. The bigger mistake to make ... would be to fail to restore price stability.", he added.The Fed chairman explained the regulator's plans while saying nothing that could boost the market's rate hike expectations. Instead, Powell implied that the interest rate outlook would depend on inflation trajectory in the upcoming months.

Current market expectations on interest rates have peaked. If inflation slows down, the Fed could put its monetary tightening cycle on hold.

Christine Lagarde confirmed that the ECB plans to increase interest rates in July and September. Furthermore, the ECB President repeatedly underlined the regulator's focus on "gradualism and optionality" - the European Central Bank is ready to adjust its policy, if necessary. "I think markets have full understanding and appreciation of what we're doing," she added.

Similar to Jerome Powell, Christine Lagarde did not say anything that would increase interest rate hike expectations in the market. The interest rate will likely rise to 1% from -0.50% by the end of this year. In addition, Lagarde did not provide any detailed information about the ECB's long-anticipated measures aimed at warding off instability in Southern European government bond markets.

"I think that this risk of fragmentation that is much talked about is something inherent to the European construction and the fact that we have 19 member states that each have respective fiscal policies and financial markets and as a result of that, our unique monetary policy has to be transmitted throughout this imperfect market of ours," Lagarde stated.

Earlier, Bank of America noted that the ECB has not developed a policy tool for achieving this goal.

"We are being hit by a very large national real income shock, which is coming from outside. The scale of the shock is very substantial and in and of itself it will have an effect, a big effect, because it will reduce domestic demand, and it will pass through into the labor market, and it will pass through into inflation," Andrew Bailey, the governor of the Bank of England, said.

"Monetary policy has, of course, a very important role to play because it will act alongside that shock," Bailey added, stating that the BoE would address the shock's impact, as stated in June. "The message that we gave and was in the language of our last meeting was that if we see greater persistence of inflation... then we will act more forcefully," the BoE's governor concluded.

The overnight index swap market has priced in a high possibility of the BoE increasing interest rates to 2.75% or more by the end of the year from 1.25%. The BoE's Market Participants Survey expects interest rates to rise to only 2%.

Currency outlook

Market players are already bearish on the pound sterling. Over the past several months, the FX market braced for an economic slowdown in the UK. However, the predicted recession in the winter of 2022 could have an ever greater impact on the euro.

Analysts note that pessimism in the market regarding the British economy and GBP has potentially peaked, making the euro more vulnerable if eurozone growth outlooks are reduced.

Barclays has slashed its eurozone GDP outlook for 2023, warning that European countries could enter a technical recession by the end of 2022.

Meanwhile, economists at Berenberg Bank say M1 money supply in the eurozone is now flashing red.

"Over the past 30 years, no chart or model has served us better to predict Eurozone growth than a look at money. Real M1 money supply often heralds major turning points in the business cycle some two to three quarters in advance. Unfortunately, the message of the chart is clear: judging by the real value of the highly liquid balances of households and non-financial companies, the Eurozone is heading for a downturn," Holger Schmieding, chief economist at Berenberg said.

A recession at the beginning of 2023 would mean the ECB has a very limited window in which to raise interest rates in an effort to bring inflation down. Falling rate hike expectations would in turn mechanically weigh on the euro.

If market players continue to downgrade eurozone's growth expectations, it would push down the euro against both the US dollar and the pound sterling.

According to UBS, EUR/GBP is expected to reach 0.8500 by the end of the year.

EUR/USD would likely resume its downward movement after its brief correction. It would encounter initial resistance at 1.0470. Bullish traders would likely not act until the pair breaks below this level.

The pair's intermediate support can be found at 1.0440, right before the psychological level of 1.0400 and the static level of 1.0380. Bearish traders currently hold the initiative.

The areas above 1.0470, 1.0500, and 1.0520 can be regarded as next technical obstacles for GBP/USD.