The EUR/USD pair’s decline appears driven by bulls exiting the market amid concerns that the ECB could launch another round of quantitative easing to support the eurozone and France. With the euro under significant pressure, the dollar has had little to do to gain the upper hand. Let’s examine the factors behind this move and develop a trading plan.
The article covers the following subjects:
Major Takeaways
- Rising political risks are dragging down the EURUSD pair.
- The ECB may need to resort to QE to support the euro.
- The Fed intends to continue raising rates.
- Short positions can be considered with targets of 1.14 and 1.13.
Weekly Fundamental Forecast for Dollar
When Mario Draghi, then president of the ECB, made his historic pledge in 2012 to do “whatever it takes” to save the euro, few could have imagined that history might repeat itself 14 years later. Today, the yield spread between French and German government bonds has widened beyond the levels seen during that period, signaling a sharp increase in perceived political risk. The growing divergence is weighing on the euro and adding further downward pressure on the EUR/USD pair.
Yield Spread Between French and German Bonds
Source: Bloomberg.
France’s public debt stands at 118% of GDP and could reach 120% by 2027. As bond yields rise, interest payments are expected to increase from roughly €66 billion today to €124 billion by the end of the decade, while the budget deficit could exceed 5.7% of GDP. This is inconsistent with EU fiscal requirements and is forcing the government to pursue measures to reduce the debt ratio. However, opposition parties controlling parliament have resisted these efforts, and similar political deadlocks have previously resulted in prime ministers’ resignations. The current situation appears to be moving toward another potential resignation, which could trigger capital outflows and push borrowing costs even higher.
The ECB may ultimately be forced to do “whatever it takes” to preserve financial stability in the euro area. The possibility of purchasing French government bonds to bring down their yields therefore cannot be ruled out. Such a move would amount to quantitative easing, a form of monetary expansion that, unlike tighter monetary policy, could push the EUR/USD even lower.
The Fed, by contrast, is not facing the same fiscal pressures. Thomas Barkin, president of the Federal Reserve Bank of Richmond, compared the central bank’s dual mandate of price stability and maximum employment to two children: while one—the labor market—is bringing home good grades, the other still needs some guidance. A single heart-to-heart conversation is unlikely to be enough. Against this backdrop, markets are currently pricing in a 54% probability of another federal funds rate hike in October.
FOMC members are also becoming increasingly concerned about second-round effects, as elevated energy prices feed through into core inflation. Moreover, a prolonged conflict in the Middle East could prompt more aggressive monetary tightening than in 2022. Around 200 days after the Ukraine conflict erupted, oil prices were about $7 per barrel below their pre-conflict level. By contrast, oil is now roughly $25 higher than it was before the US and Israeli airstrikes on Iranian territory in late February.
Oil Prices During Geopolitical Conflicts
Source: Wall Street Journal.
Morgan Stanley estimates that inflation could reach 2.7% by the end of 2027, above the Fed’s 2.5% forecast. If inflation remains elevated for longer, additional rate hikes may be necessary, a scenario that could provide further support for the US dollar.
Weekly Trading Plan for EUR/USD
Thus, rising political risks in Europe, combined with the prospect of an acceleration in the Fed’s monetary tightening cycle, are pushing the EUR/USD pair toward 1.14 and 1.13. As a result, consider short positions.
This forecast is based on the analysis of fundamental factors, including official statements from financial institutions and regulators, various geopolitical and economic developments, and statistical data. Historical market data are also considered.
Price chart of EURUSD in real time mode
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