- EUR/USD is closely tied to the fluctuations in short-term yield differentials between the US and Europe.
- Upcoming US CPI report and ECB monetary policy decisions will heavily influence central bank interest rate trajectories.
- Persistently high inflation in the US may limit speculation regarding future Federal Reserve rate cuts.
- Expectations of a more aggressive ECB rate-cutting strategy could present downward risks for the euro.
Market Dynamics
A recent convergence in yield differentials between the US and European markets has allowed the EUR/USD pair to stage a recovery, briefly surpassing the resistance level at 1.0600 last Friday. This adjustment in yield spread primarily stems from a reassessment of US interest rate expectations; however, barring any significant surprises in the US core inflation report due Wednesday, the trajectory of the spreads and the EUR/USD currency pair may largely hinge on developments from the ECB's policy meeting on Thursday.
Influence of Central Banks
Although the correlation has eased somewhat in recent weeks, the Euro to US Dollar exchange rate remains significantly affected by US-German yield differentials, especially at the shorter end of the yield curve where central bank anticipations prevail.
Source: TradingView
The illustration above demonstrates the interplay between the EUR/USD exchange rate and the two-year US-German yield spreads, with the spreads' scale inverted to highlight their importance in recent months. Notably, as these short-term spreads contracted to their lowest levels in several weeks after the US payrolls data release on Friday, the EUR/USD pair surged to its highest levels in multiple weeks.
Key Economic Indicators Ahead
With the direction of the EUR/USD exchange rate closely tied to central bank policies, traders should closely monitor events that could alter rate projections for both the US and the eurozone.
In the US, the critical event this week is the CPI report set for Wednesday. A 0.3% increase in core inflation for November is anticipated, consistent with readings from the previous three months, maintaining an annual rate of 3.3%. Although this measure is not favored by the Fed, a consistent monthly gain of 0.3% translates to an annualized rate of 3.6%, nearly twice the 2% inflation target.
If the inflation results align with expectations, it would reinforce current market assessments, suggesting that the Fed may only implement two rate cuts over the next four FOMC meetings. More aggressive cuts amid persistent inflation could potentially reignite upward price pressures, especially given the strength of the labor market.
On the European side, the spotlight is on the ECB. The magnitude of the anticipated rate cut in December and the revised inflation outlook will be crucial for shaping market expectations. The markets are currently betting on a 25-basis point reduction at the ECB's meeting this December, with a slim 15% chance of a larger 50-basis point move. Predictions also included a total of 75 basis points in cuts by the end of next year. Any alterations in the expected rate trajectory are likely to sway short-term European bond yields, making this week's ECB meeting a pivotal moment for the EUR/USD exchange rate.
Technical Analysis of EUR/USD
Source: TradingView
The failure to maintain a position above 1.0600 last Friday, despite favorable conditions in the US-German yield differentials, may be seen as a setback for bullish traders. This highlights the importance of remaining attentive to market behavior, even as yield trends indicate a clear direction.
Currently, the MACD and RSI (14) indicators are showing bullish momentum. However, for traders to gain more confidence in a potential upward movement for the EUR/USD pair, a definitive break and close above the 1.0600 mark is required. This level has proven to be a hurdle, with five unsuccessful attempts to breach it since November 18.
A successful close above this level would place 1.0666 and the 50-day moving average at 1.07397 on the radar, allowing traders to implement protective stops below this key level. Conversely, if the market cannot establish a sustained presence above 1.0600, the alternative strategy would be to consider selling as the price approaches this key level, with stop losses positioned above. The next minor support levels are at 1.0544 and 1.0461, which could lead to a retest of the November lows at 1.0333.
