EUR/USD Rebound Looks Untenable as ECB, Fed Policy Divergence Grows Amid War Risks

Euro, EUR/USD, ECB, Inflation, Ukraine, Central Bank Divergence – Talking Points

• Euro traders eye European Central Bank this week after rate hike bets cut
• Tensions in Ukraine weigh heavy on the Eurozone’s economic outlook
• Sustained EUR/USD rebound unlikely given growing Fed/ECB policy divergence

The Euro is unlikely to find much support from the European Central Bank’s policy decision this week after the Ukraine crisis saw markets cut rate hike bets for the central bank. The ECB is expected to keep rates steady on Thursday, in the first major central bank policy decision following Russia’s invasion into Ukraine. That is a reversal from just a couple of months ago when bond traders were pricing in the ECB’s first hike since 2011.

Geopolitical risks from Ukraine, just outside the European Union’s border, are expected to have an outsized impact on the Euro Zone economy. A volley of Western sanctions targeting Russia has thrown considerable uncertainty into forecasting economic activity in the short term while at the same time driving inflation expectations higher. German breakeven rates have soared to record highs, with the 5-year measure rising to 3.088% on Wednesday.

The European Union is reportedly planning to increase fiscal spending to fund the defense and energy sectors, which helped to spur a rebound in EUR/USD overnight, although the currency pair remains near its lowest levels since May 2020. The chance for an extended rally looks small, given the current landscape. Europe’s inflation woes are being driven largely by supply-side energy prices. That limits the ECB’s options, as monetary policy is better suited to address demand-side issues in an economy.

That said, Euro bulls may be waiting on the sidelines for some time and are largely at the mercy of the course of the war in Ukraine. Even if the unlikely scenario of a near-term de-escalation occurs, it won’t necessarily provide an immediate pullback in energy prices across the bloc. The Euro will likely stay depressed versus the Greenback due to the growing divergence between ECB and Federal Reserve policy, with the Fed expected to hike rates next week by 25 basis points. Meanwhile, the Euro is expected to see volatile trading ahead, evidenced by highly elevated 1-month and 1-year at-the-money volatility option pricing (see chart below).

— Written by Thomas Westwater, Analyst for DailyFX.com

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