The foreign exchange market (known as forex) is highly liquid and has trillions of dollars worth in currency traded each day. With this highly liquid market, it is inevitable that currency values will rapidly fluctuate. In order to stay ahead of the curve, it is important to not just watch the changes and fluctuations, but why they are happening.
The Forex market, more than any other trading market, is significantly affected by a wide range of outside factors and is the largest financial market in the world. The market operates through the trading of currency values against other currencies. The highly volatile market can go through significant changes that increase or decrease currency pairs’ values over a matter of months, weeks, or even a few hours.
The concept of forex trading, such as using a contract for difference (CFD) to profit from price movement speculation, is based on the understanding of how certain factors cause these changes. For example, you can understand how the Euro performed in the recent past by analyzing how one of the most traded currencies changed over this time period.
Read on as we show you how the EUR stack up to five other currencies over the last five months, and how measuring these changes can help you decide whether to buy or sell the Euro moving forwards.
Since the euro is one of the biggest currencies in the world, and the U.S. dollar is another of the biggest currencies in the world, the EUR/USD is a good representation of their value. At the start of October, the EURO entered the month at 1.16 USD, which stayed fairly constant until the beginning of November. That’s when the EURO began to fall moderately, having ended on 1.12 USD by the beginning of December.
The main reason for this sudden decline is the impact of the COVID-19 pandemic. In November, many European countries returned to more severe lockdown restrictions. Additionally, Omicron had made a huge impact on Europe. When there were fewer people available to work and less money in the economy, naturally there was a big hit to the economy. The Eurozone (Europe’s economy) recorded a record high inflation rate of 4.9%. All of these factors may explain the recent drop in the value of the Euro (EUR).
Throughout December, the EUR averaged about 1.25 USD, declining slightly from the impact of the coronavirus in November, but then it increased on January 30th, reaching 1.14 USD on February 4th. It began in January at around 1.1 USD.
The US dollar dropped in value against many currencies after the US Federal Reserve Chairman Powell predicted huge interest rate hikes on January 26th. The increase would lead to an increase in the cost of borrowing money, which investors would not want to pay, thus decreasing the demand for US dollars.
The EUR to USD exchange rate, or the value of European Euros in American Dollars, sits at 1.13 as of February 22nd. This is a temporary fluctuation in the value, which is rising and falling with current world events. Russia has recently made advances in its cause to take over Ukraine. This could be why the EUR to USD value has been dipping.
Traders are all around the world beginning to strategize their investments in anticipation of this event; if it is followed through, the euro and the dollar might have greater equality in value. Moving forward into March, the European Union (EUR) will likely experience a vast number of changes in value due to the impacts of coronaviruses and US interest rates. There is also a potential invasion of Ukraine, which will help keep EUR value predictions accurate.
Post-ECB Meeting USD/EUR
With the European Central Bank (ECB) dropping its forward guidance about interest rate changes and markets speculating about a hike in 2022, the euro may find itself stuck between $1.13 and $1.15 in the run-up to the pivotal ECB meeting on March 10. In the medium term, we expect the euro to continue to fall in value, although any overly aggressive expectations of an interest rate hike should keep it from plummeting too far.
Christine Lagarde’s press conference today reflected a hawkish stance on inflation risks. Recent shifts in ECB policy have escalated the market’s view of inflation and interest rates, and Lagarde seemed inclined to provide another update on the ECB’s guidance after March. The markets also appear ready for an interest rate increase by 2022, and Lagarde reinforced this view by dropping language regarding the ECB’s commitment to low-interest rates in 2022.
All of this has clearly paved the way for markets to speculate quite freely about a change in the central bank’s forward guidance. The market reaction saw eurozone bonds sell off sharply; the December 2023 euro swaps rose about 30 ticks. The markets moved to price in a first-rate hike in June 2022 and around 50 basis points of tightening by the end of the year. The euro also increased in value to 1.14 against the U.S. dollar.
EUR/USD to consolidate within 1.13-1.15 into the March ECB meeting
Market observers saw the EUR/USD currency pair post a sharp rise today after last week's fall towards two-year lows. Some combination of increasing strength of the EUR since Monday's high inflation numbers and a generalised weak dollar environment caused by data showing softer US economic growth and investors responding to their positions caused the strong EUR rebound. Meanwhile, we suspect that the dollar will have to find new support after tomorrow's release of a likely subdued report on employment at the end of January, which should help to keep up EUR/USD gains.
Incidentally, a market that is speculating on an ECB move to raise interest rates should continue to support the euro over the next few weeks. That's because even if the market is right overall, it may not be strongly challenged until the 10 March meeting itself. We now believe that the EUR/USD price during the post-FOMC period of 1.11-1.13 has been replaced by a range of 1.13-1.15, which may last until the March ECB meeting.
The 1.1130 lows in EUR/USD had embedded a wide divergence in monetary policy outlooks between the US and the Eurozone. As shown in the chart below, the differential between US and German 2-year yields rose to its peak in over three months after the Fed’s hawkish message.
After the ECB dropped its dovish forward guidance, markets priced in multiple interest-rate hikes by the Fed. It’s not unreasonable to conclude that the peak of the Fed-ECB policy divergence is over. Accordingly, and given how important rate differentials are to the dollar’s value in the current market environment, one might argue that the euro touched a cyclical bottom last week.
We are not ready to shift to a medium-term bullish outlook on the Euro against the US Dollar, as we doubt that a 2022 rate hike in the Eurozone will come before the fourth quarter of this year. Although ECB rate expectations are aggressive, we expect some re-pricing of them in the coming months. In contrast, the market’s pricing of Fed tightening (five hikes in 2022) is consistent with our economists’ forecast, and is not as aggressive as the ECB pricing, given that three hikes already appear in the FOMC Dot Plot for this year.
G10 FX Outlook 2022: Mid-cycle dollar strength
If equity markets are a reflection of confidence in global economies, then the stellar returns this year have some policymakers excited. G10 economies are bouncing back and concerns about a long recession have shifted to worries about high inflation.
Output gaps can be used to determine when countries will tighten monetary policy. In 2022, output gaps are expected to be positive in the US (3.3%) and in Canada (0.8%). The Fed and the Bank of Canada should be tightening by then.
Both the Euro area and Japan have experienced negative output gaps since 2008, and it is likely that the same trend will continue, justifying the more entrenched dovish monetary policies of those central banks. Though it seems a very much consensus view, we do favour dollar strength during the Fed lift-off period and will likely sell the Euro, Japanese yen, and Swiss francs, which are less tolerant of higher inflation. We may also lag on the Swedish krona.
We do not think that a stronger dollar against low-yield currencies changes the risk environment. Right now, the global economy is probably in mid-cycle, with economic confidence growing, inflation picking up and central banks beginning to tighten rates. This should allow most commodity currencies to continue performing well during their economies' realization that the benefits of recent terms of trade gains will lead to higher business investment.
Over the next three years, GBP will probably fall somewhere between the three stools of a strong dollar, weaker low yielders, and steady commodity currencies. We think GBP can hold onto its 2021 gains unlike a market generally more pessimistic on the pound.
Lastly, we’d like to provide a medium-term forecast for currency exchange rates, using our Behavioral Equilibrium Exchange Rate (BEER) model. Recent terms of trade changes have depressed the Euro-Dollar rate to around 1.10. That is our year-end 2022 forecast, which is well below the consensus of 1.18. Of the currencies in our BEER model, we would favour the Norwegian Kroner and the New Zealand Dollar playing catch-up. We are bearish on the Japanese Yen and the Australian Dollar in 2022, and although the American Dollar may benefit from being undervalued, it remains a high-risk proposition.
The Future Likely Leads to a Stronger Dollar
The move in the dollar this year was driven by the Fed. Instead of unchanged policy and negative real US rates out to 2024, it now looks as though it may raise rates next summer. The Dot Plots have been a big driver of the dollar run and, even now, money market curves are still far below Fed projections for the policy rate. Some good economic momentum going into 2022 (we forecast GDP at 5%) backed by strong corporate and consumer balance sheets should hold pricing power and keep inflation above 3% all year. A stronger dollar can play a role in tightening monetary conditions.
Economists’ ECB rate expectations dampened: The market’s pricing of the ECB interest rate path also fell foul of the energy price shock and at one point nearly 30 basis points of interest rate hikes were priced in for 2022. We view those expectations as extreme and unlikely, although the eurozone may need to wait until next spring for inflation to rise enough to blunt those expectations. The eurozone is still expected to run a 0.5 percent GDP deficit in 2022, and the ECB has made it pretty clear it does not want to repeat the mistakes that Trichet made by raising interest rates in July 2008.
Stagflation? Probably the only risk to the above scenario is stagflation, where early hikes trigger a recession. The current Fed seems light years away from the Volcker Fed of the early 1980s, so we think this scenario is unlikely. Even if stagflation were to materialise, it would probably be negative for risk assets and provide support for the anti-cyclical dollar. Perhaps the only scenario for a stronger euro would be a strong global recovery, a eurozone renaissance (as occurred in 2017) and a Fed turning dovish. Supply chain disruptions that weigh on manufacturing growth in Europe next year make this scenario unlikely.
We hope this article proves to be useful when it comes to helping you gain a better understanding of USD/EUR movements in February. While nothing that we’ve discussed here is a sure thing, the information that we’ve laid out should come in handy when determining your actions moving forward. Be sure to keep everything you’ve learned here in mind so that you can make the most informed decisions possible.
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