10.02.202216:06 Forex Analysis & Reviews: EUR/USD goes in circles, taking one step forward and two steps back

Since the beginning of the week, the EUR/USD pair has been marking time, fluctuating within 50 points.

The results of the Fed and ECB meetings, which were more "hawkish" than expected, took the markets by surprise and led to a sharp increase in the yields of eurozone and US debt obligations in anticipation that interest rates on both sides of the Atlantic could rise faster and stronger than previously expected.

The European government bond market reacted violently to the rhetoric of the head of the ECB, Christine Lagarde, who last Thursday did not rule out the scenario of raising rates this year.

ECB Governing Council member Klaas Knot continued on Sunday, saying he expects the regulator to raise interest rates in the fourth quarter of this year.

In a matter of days, the yield on 10-year Italian government bonds jumped from 1.4% to 1.8%, and on their counterparts from 1.8% to 2.5%, while risk premiums on the debt of these countries increased compared to ultra-reliable Germany.

The yield on 10-year German bonds, which recently returned to positive territory, continued to rise and reached 0.24%.

On Monday, Lagarde tried to reassure investors that any changes in the ECB's policy would be gradual.

"There is no indication that a tangible tightening of monetary policy is needed," Lagarde said.

Her comments slowed yield growth, but did not reverse it.

Lagarde's assurances that the ECB has many tools to control spreads, including the reinvestment of income from maturing bonds purchased under the quantitative easing (QE) program, also did not reassure investors.

"The spreads widened dramatically because if we don't have QE, what are the tools? We only have investments but whether that's enough, no one seems to believe it," UniCredit experts said.

On the other side of the Atlantic, in anticipation of the Fed's move to raise interest rates, investors continue to dump bonds. As a result, 10-year Treasury yields have already risen above 1.9%, the highest since July 2019.

Clearly, government bond markets are facing another surge in volatility as central banks adjust their monetary policy outlook.

The ECB and Fed appear to be looking to maintain maximum flexibility amid the uncertainty surrounding the ongoing COVID-19 pandemic.

However, investors cannot afford to be as indecisive as politicians, and therefore markets tend to overreact to events.

It is possible that sooner or later investors will return to some sense of reality and realize that the idea of up to seven Fed rate hikes this year is too aggressive and unlikely to happen.

In addition, they may conclude that the market bet on a eurozone rate hike of more than 50 basis points, or about two 25 basis point rate hikes, by the end of the year looks excessive.

Such expectations have already caused some topsy-turvy reaction of the market, which is reflected in the dynamics of the EUR/USD pair, which cannot yet decide on the direction of movement.

The euro continues to receive support from the "hawkish" shift in the policy of the ECB, which continues to push up the yield of eurozone government bonds.

However, rising bets on a 50 basis point Fed rate hike in March are acting as a tailwind to treasury and dollar yields.

The 10-year US Treasury yield is already in close proximity to the psychological 2%. Exceeding this level can serve as a catalyst for the rise of the USD.

However, further gains in the United States, even along the entire curve, may not necessarily support the greenback.

The fact is that the bond yield spread between the 10-year US and German government bonds has narrowed to 170 basis points.

The change in the spread of 10-year government bonds of Germany and America suggests an increase in the EUR/USD pair to 1.1483-1.1610 and, possibly, to 1.1700, Citigroup strategists believe.

Saxo Bank specialists do not share this point of view and are not yet ready to join the expectations of a higher value of the euro.

"First of all, the widening yield spreads between the core and the periphery of the eurozone, which immediately appeared after the January meeting of the ECB, cause concern. This is especially true for Italy. The ECB and/or the EU policymakers need to get ahead of this source of existential anxiety, or problems will reappear that could repeat the experience of 2010-2012. The second issue is the growing strain manifesting in corporate credit spreads, which have rapidly risen to new cyclical highs across all corporate debt ratings in Europe. All of this is worth watching closely," they said.

As for the United States, the focus of attention throughout the week is the US inflation data for January, which will be made public on Thursday and may become a determinant for the Fed's monetary rate.

Last month, consumer prices in the US accelerated from 7% in December to 7.3%, the highest since June 1982, according to forecasts.

The key release of the week can cause a surge in volatility in the foreign exchange market, affect the dynamics of the dollar and give a new impetus to the EUR/USD pair.

It is possible that the reaction of the market may turn out to be very restrained, since strong price pressure is already largely priced in, as is the Fed's vigorous monetary tightening this year.

Dollar bulls are waiting for the CPI report with the hope that it will reflect the rise in prices to new 40-year highs and further strengthen expectations of a Fed rate hike in March, possibly by 0.5% right away.

However, the only scenario in which the USD will react tangibly higher will be a noticeable excess of the real figures of the forecasts. In this case, expectations of a federal funds rate hike in March will immediately increase by 50 basis points, and with them the dollar.

If the report reflects an unexpected slowdown in consumer price growth, this could lead to a noticeable drawdown in the USD, the additional acceleration of which will give an improvement in risk appetite, as the CPI decline moderates market expectations for Fed rates.

However, to revise the planned rate hikes, the regulator will need several months of steady decline in inflation.

"There is some evidence we are on the cusp of inflation that begins to ease perhaps by midyear," said Atlanta Fed President Raphael Bostic.

Cleveland Fed President Loretta Mester also expects inflation to ease this year as the Fed steadily tightens lending conditions.

The futures market has a 23% chance of a 50 basis point hike in the federal funds rate in March.

Higher-than-expected US inflation figures for January could lead investors to see a higher chance of a 0.5% rate hike at the next FOMC meeting, which will support the greenback.

Weak inflation readings will leave the dollar in the background and help the EUR/USD pair, which still struggles to make a decisive move in either direction, gain momentum.

On Wednesday, it attracted buyers near 1.1400, broke a two-day fall and ended trading with a symbolic increase. On Thursday, the pair continued to move sideways as investors took a wait-and-see approach ahead of the release of January US inflation data.

Initial resistance is in the 1.1450-1.1460 area. This is followed by this year's peak near 1.1480 and round 1.1500. Breakdown of these marks will open the way to additional growth. The pair could then head towards 1.1550 before trying to return to 1.1600 for the first time since November 2021.

On the other hand, a break below 1.1400 would target the bears at 1.1350 on their way to 1.1300. Failure to hold above 1.1285-1.1280 will be a new trigger for sellers and leave the pair vulnerable to a slide to 1.1200 and then to 1.1150 and 1.1120.