18.01.202316:50 Forex Analysis & Reviews: EURUSD rally mainly due to monetary policy

While the World Economic Forum in Davos discusses which emotions the markets will experience more from the opening of China—caution or optimism—EURUSD froze just above 1.08. Good news is increasingly coming from Europe, including German Chancellor Olaf Scholz's statement that Germany will avoid a recession. The first inflows of capital into ETFs for European stocks since the beginning of the armed conflict in Ukraine and the positive from German business confidence are all a source of joy for euro fans.

According to Goldman Sachs research, U.S. equity-focused ETFs lost about $5 billion in the first two weeks of January. Money is flowing from the U.S. to Europe and emerging markets as American exceptionalism is a thing of the past. There are economies that will grow faster in 2023 than the United States. Capital outflows contribute to the weakening of the U.S. dollar, although the main driver of the EURUSD rally is monetary policy.

Dynamics of capital flows to funds

The Fed has run out of steam. It is ending a cycle of monetary restriction. Even if the federal funds rate does not fall this year, as financial markets dream, it will fall in early 2024. The ECB will keep borrowing costs at an expected peak until the middle of next year, creating a bullish tailwind for EURUSD.

This scenario suggests that U.S. Treasury yields are likely to have already peaked. Unlike German debt and swap rates, which could still rise. As a result, the yield differential shows that the major currency pair should trade at 1.2. The euro looks undervalued.

Dynamics of EURUSD and interest rate swap differential

It is not yet clear how the energy crisis will affect the ECB's outlook. More precisely, its absence. On the one hand, the fall in gas prices will contribute to a slowdown in CPI in the eurozone, which may reduce the degree of aggression of the "hawks" of the Governing Council. On the other hand, the favorable situation in the blue fuel market will increase the stability of the eurozone economy. It will be able to handle higher rates than currently assumed.

I believe that the ECB will decide to play it safe and increase the cost of borrowing by 50 bps both in February and March, as Christine Lagarde said before. Despite a Bloomberg insider claiming that the Governing Council is considering reducing the step to a quarter of a point at the March meeting.

In my opinion, due to the opening of China, the stability of the European and the strength of the U.S. economy, optimism will prevail in the markets in the first half of the year, which will favorably affect global stock indices, global risk appetite and the major currency pair.

Technically, after a stormy rally in November–January, EURUSD decided to take a break and went into consolidation. A break of its upper border near 1.087, as well as pullbacks to the supports at 1.075 and 1.069 will be grounds for buying the euro.