EURUSD is one of the highest-traded currency pairs in the world. Both legs of the pair represent two of the largest economic power centres globally, the United States and the European Union. EURUSD has been in a consolidation mode since September last year. The price touched a high of 1.2267 right before the end of 2020 which also marked the election of President Joe Biden. From then onwards, EURUSD saw a steady decline, reaching a YTD low of 1.176 in late march. It then saw a bounce from that level till late May and then retreated back close to YTD low.
Before we look at the possible paths EURUSD will take in the next few weeks, let us get a brief understanding of the fundamentals of the currency. Any change in EURUSD typically represents the relative change in the dynamics of the US and the European Union. For example the December 2020 elections marked a major political change in the US while the political leadership in the EU remained stable during that time, which is why we saw a massive price move.
Pandemic and Quantitative Easing
That is also why the global events that have an equal impact on both these regions will not have a significant impact on the price. Rather we have to be on the lookout for events that create a significant differential between the two economies. Post the pandemic, central banks of both the region, the Federal Reserve of the US and the European Central Bank (ECB) have undertaken massive easing measures. This was done to support the economy which was reeling under the impact of the lockdowns imposed to control the ongoing pandemic.
This has created huge liquidity in the system where both central banks have bought large amounts of bonds and pumped cash back in the system. This was done to keep interest rates low so that businesses can borrow easily. However this was done as an emergency measure and is clearly not sustainable. Whenever a central bank increases money supply it adversely affects the strength of the domestic currency. The Federal Reserve’s massive quantitative easing has kept USD strength in check. Similarly ECB’s incessant bond purchases have kept the EUR under pressure as well. If these central banks decide to decrease their supportive measures, their currencies will see a sharp appreciation.
Federal Reserve and ECB set to diverge
Now if both central banks decide to cut back on their easing programs at the same time by the same magnitude, it will not have a significant impact on EURUSD. However, statements from Jerome Powell, Federal Reserve’s chairman and Christine Lagarde, ECB’s president show that two are set to diverge and diverge very soon.
In its meeting last month, the ECB stated that in the next quarter, it will continue to purchase bonds at a rate higher than previously seen in the initial months of 2021. This clearly indicates the ECB’s intentions to not scale back the bond purchases. In fact it intends to purchase them at an even higher rate in the next quarter. As can be seen below, ECB’s balance sheet rise still lags that of the Federal Reserve.
When it comes to decreasing the purchases, growth and inflation are two major factors. If the growth remains low, the continuation of these purchases remains critical. If economic growth picks up, the central bank can afford to go slow on these. In case of inflation, the reverse holds true. One of the objectives of central banks is to control inflation. So if these easing measures start causing inflation then the banks will need to taper their purchases.
For the Eurozone, ECB stated in its latest meeting that it expects inflation to be 1.4%, slightly below its target of 2%. This means ECB does not see inflation as a major concern although it does see growth outlook improving.
The next taper seems to be around the corner
Now coming to the Federal Reserve, its statements were in stark contrast to those of the ECB. In its meeting that happened 1 week after the ECB meeting, the Federal Reserve adjusted its inflation expectations higher. Further, the members of the Federal Open Market Committee (FOMC) which decide the rates indicated that they now expect 2 rate hikes by 2023. The financial markets reacted negatively to this news and the Federal Reserve then had to put out some reassuring statements to soothe the markets. But it was clear that the Federal Reserve was setting up the stage for tapering the purchases.
Both the Federal Reserve and the ECB have their meetings every 6 weeks. The next ECB meeting is scheduled on 22nd July while the next FOMC meeting is scheduled on 28th July. The ECB is widely expected to maintain the status quo regarding its approach to bond purchases. On the other hand there is a high probability that the Fed, having set up the stage in the previous meeting, might finally take the chance to announce a tapering of the purchases. This could be a massive catalyst as USD will see a massive strengthening move.
Something similar had happened in 2013 when the Fed decided to taper its purchases that it had begun in 2008 post the great recession. As you can see in the chart below, post the tapering speech, many currencies depreciated vs USD with EUR being a major one.
This time around, the impact on EURUSD will be much more significant because the ECB has already committed to increasing its bond purchases. So it is very likely that the EURUSD pair will breach the strong support levels seen at 1.16. The price had bounced back from that level on two occasions as seen in the first price chart above. So if the EURUSD manages to breach that level, we are likely to see a very sharp breakdown move in the currency pair.
The trigger clearly would be the next FOMC meeting on 28th July and also the minutes of the meeting which are typically shared 2 to 3 weeks post the meeting. The statement of the Fed chairman Jerome Powell and other members of the FOMC will be closely watched. Any signs of tapering would be a trigger for a massive move in EURUSD.