EUR/USD has today sunk to its lowest levels since mid-March as demand for USDs coincides with a less positive story for the EUR.  In our view, positioning can help explain the move lower, with the market keen to build long dollar positions at a time when investors are likely having second thoughts about the recent build-up of EUR longs. The currency pair is comfortably on course for hitting our H2 target of EUR/USD1.06. 

The EUR has had a good run. It rallied vs. the USD through the end of last year into early Feb and again from early March to its late April high.  CFTC data suggest that by mid-May speculators had built up their longest net EUR positions since September 2020. The outlook for the EUR improved markedly at the end of last year as European gas priced started to plummet from their highs. This put paid to fears about energy black outs during the winter months and stoked hope of a better outlook for the Eurozone economy.

The optimism found further support around the turn of the year with hopes that the re-opening of China from its Covid lockdowns would stimulate global demand and provide a boost to activity in Europe; China is Germany’s largest export partner.

However, recent PMI data showing weakness in German new manufacturing orders has coincided with recent data showing soft Chinese domestic consumption data.

Last week a revision to German Q1 GDP data showed that European’s largest economy has failed to avoid a winter recession afterall. At the same time, the rapid pace of ECB tightening had led to a sharp tightening of credit conditions in the Eurozone.  While higher rates are currency supportive, there can be be a tipping point after which growth concerns start to outweigh the currency positive connotations of higher short-term interest rates.

Yesterday, the ECB warned about "stressed" liquidity due to heightened economic uncertainty, monetary policy normalisation and tighter financial conditions.  Although ECB President Lagarde has warned that policymakers have more to do to push back against price pressures, signs of moderation in May CPI inflation readings in parts of the Eurozone underpin that the ECB is likely on the last leg of its monetary tightening journey. The market is already comfortably priced for further rate hikes and moderating price data and the threat that the Eurozone is facing stagnation in H2 suggest that the EUR can sink further vs. the USD in the coming weeks.

While some Eurozone May CPI inflation data have undershot the market consensus, US data has largely not been playing along with the view that the Fed policy-makers can afford to relax. The front end of the treasury curve has remained sensitive to speculation regarding the possibility of further Fed tightening, if not in June than potentially in July.

Additionally, it remains our view that the Fed will not be cutting rates until 2024.  Friday’s release of stronger than expected PCE deflator data served to support the ‘higher for longer’ view on Fed rates. The headline measure rose to 4.4% y/y in April while the core edged up to 4.7% well above the Fed’s target for stable price pressures. The USD found support on these data on Friday and, while the DXY dollar index traded off its recent high earlier this week, it has crept higher again today.

Strong demand for USDs is evident in the fact that commentators have attributed some of its recent gains to safe haven flow due to debt ceiling concerns, and also to the news that a deal has been done. This is suggestive of broad based demand based on a variety of drivers. In our view, the risk that the US may fall in recession this year, combined with a disappointing recovery in China and stagnation risks in the Eurozone do not bode well for risk appetite. In this environment, the USD is likely to find support.