Although the US and eurozone economies both appear strong, they respond differently to developments in the oil and petroleum products markets. Europe, in particular, tends to face higher energy costs. Let’s explore this dynamic and develop a trading plan for the EUR/USD pair.
The article covers the following subjects:
Major Takeaways
- Oil is affecting the US debt market.
- The rally in Treasury yields is supporting the US dollar.
- The eurozone is forced to pay for energy.
- Short positions can be considered as long as the EUR/USD pair remains below 1.1400.
Weekly Fundamental Forecast for Dollar
If the US economy can withstand high interest rates, why couldn’t it withstand higher oil prices? The correlation between Treasury yields and oil prices has reached record levels, putting the commodities market firmly in investors’ focus. The higher Brent crude rises, the greater the risk of renewed inflationary pressure and more aggressive monetary tightening by the Fed. At the same time, higher yields tend to support the US dollar.
Correlation Between Oil Prices and Treasury Yields
Source: Wall Street Journal.
Logic suggests that a rally in oil prices should initially push short-term bond yields higher, as these maturities are particularly sensitive to expectations for Fed monetary policy. At the same time, long-term Treasury yields should rise if Brent continues its unchecked advance. However, if Brent stabilizes around $100 per barrel, it should not add further inflationary pressure. Instead, persistently high energy costs could weigh on economic activity and eventually slow price growth.
Does this mean the Treasury market is making a colossal mistake by reacting so strongly to Brent? Not necessarily. Elevated energy prices could prompt governments to introduce protective measures, increasing budget deficits and public debt and, in turn, putting upward pressure on Treasury yields. Another possibility is that the US economy is simply strong enough—partly because of the AI-driven investment boom—to absorb higher oil costs. If so, the bond market’s pricing may be justified, as may the roughly 50% probability that the Fed will tighten monetary policy by 100 basis points over the next 12 months.
Interestingly, the eurozone economy also appears resilient. The PMI has risen to a three-year high, while the IFO German Business Climate Index has climbed for five consecutive months. Moreover, statements from the European Commission indicating that it does not anticipate a diesel shortage in the region appear to have reduced the risk of an energy crisis. At the same time, price differentials for petroleum products between Europe and the US are considerably narrower than they were in 2022.
Europe-US Diesel Fuel Spread
Source: Bloomberg.
However, an important distinction needs to be made. The US is a net exporter of energy products, meaning that rising energy prices can benefit its economy. The eurozone, by contrast, is a net importer and therefore has to pay for energy—and at a higher cost. As a result, the link between oil prices, inflation, and monetary policy is stronger in the eurozone. Moreover, there are risks that the ECB could overreact to an energy-driven inflation shock and push the economy into recession.
Against this backdrop, the market-implied probability of the Fed continuing its tightening cycle in October stands at 70%, higher than the probability of an ECB hike. As a result, the euro is coming under severe pressure.
Weekly Trading Plan for EUR/USD
Since corrections are an inevitable part of any long-term trend, a rebound in the EUR/USD above 1.1400 could create an opportunity for a short-term long position. Until that happens, however, the focus remains on selling, with downside targets at 1.1300 and 1.1200.
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.
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