Currency Risk Fed pause could cause temporary increase EUR/USD

What scenario is the most likely?

US employment data issued early January was very strong. This has fuelled concerns that the Fed will continue to downscale its balance sheet and hike its rates for the time being. This is basically positive for the dollar.

However, it should be feared that this will fairly soon lead to more downward pressure on asset prices. In combination with other US economic data issued lately – which was indicative of weakness – this will probably be enough reason for the central bank to refrain from hiking its rates for the time being. This could actually weaken the dollar.

Nevertheless, it should be borne in mind that the European economy is not in a better state. Therefore, if the dollar were to weaken, this would equally apply to the euro.

However, large long-dollar positions are still evident. EUR/USD could therefore easily rise to 1.18-1.20 if asset prices were to decline further, if said positions have to be liquidated because fewer rate hikes are anticipated. It should also be considered that EUR/USD has been fluctuating within an abnormally limited range for a period of time. Experience shows that this is usually followed by a fierce increase or decline.

 

However, even if EUR/USD were to rise to 1.18-1.20 now, we still believe that the main direction for the pair will be downward. In the medium term, we still anticipate a decline towards 1.00. This is due to a weak euro and a US economy that is increasingly nearing its capacity limits. We believe the latter will continue to ensure that the Fed pursues a relatively tight monetary policy compared to the ECB.

Short term

A breakout above 1.155 would mean EUR/USD is very likely to rise further to 1.18-1.20. However, a decline below 1.13 would point to a further decline, first of all to 1.08 and subsequently to even lower levels.

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