03.03.202216:04 Forex Analysis & Reviews: EUR/USD: US dollar and euro continue to fight while Fed and ECB choose between geopolitics and inflation

The situation in global markets remains turbulent.

Investors keep trying to assess the consequences of both the Russian military special operation in Ukraine and the harsh economic sanctions of the West against Russia.

Stock and bond prices are fluctuating because of conflicting stimuli, and there is no indication of what might prevail: war, which threatens to undermine a fragile global economic recovery, or inflation, caused by a spike in oil prices that central banks cannot ignore.

The yield on 10-year US Treasuries rose to 1.862% yesterday, posting its biggest one-day gain since March 18, 2020. Yesterday, the indicator fell by 12.8 b.p., reaching 1.708%.

On Wednesday, the S&P 500 climbed by more than 1% for the sixth time during the previous seven trading sessions.

At the end of yesterday's trading, the index increased by 1.86% after having declined by 1.55% on Tuesday.

Experts say such strong fluctuations reflect the fragility of the market.

Another similar pattern can be seen in the foreign exchange market, where volatility this week jumped to its highest level in 14 months, according to the corresponding Deutsche Bank index.

On Wednesday, the EUR/USD pair fell to its lowest level since May 2020 at 1.1060, then rebounded to 1.1130 and finished the session almost at the same level where it started near 1.1125.

The US currency continues to be in demand as a safe haven asset due to the tense situation around Ukraine.

The day before, the USD index rose for the third straight day and marked new yearly peaks in the range of 97.80-97.85.

Investors are still avoiding the euro, fearing that it is the eurozone that will suffer the most economic damage among developed countries because of the situation in Ukraine.

"In the current crisis, we view the euro's status as vulnerable," Rabobank experts said.

"On a corporate level, there is a web of complex relationships between the European Union and Russian firms, particularly in the energy sector," they added.

Jefferies experts say that many expect the euro to fall below $1.10 against the US dollar.

They said that the market could get to that point if the situation continues to deteriorate, and it could continue to deteriorate, but if we see a resolution to the conflict, the euro could jump against the US dollar.

So far it is difficult to predict further developments in the geopolitical situation, but if we assume that eventually, the geopolitical premium will leave the euro exchange rate and the market will return to the normal state, the EUR/USD pair will be able to recoup its losses.

However, until a solution to the crisis is found, the pair is likely to remain under pressure.

According to Westpac economists, the EUR/USD is still at risk of breaking through the 1,000.

"Continued Ukrainian conflict will weigh on EUR and regional rates, countering higher and persistent inflation," they said.

"EUR/USD is unlikely to sustain rebounds. Resistance is likely in front of 1.1300 with mounting pressure to test 1.1000 or even force a flush towards 1.0775-00," the economists added.

The continuing divergence of the Fed's monetary policy compared to the ECB's policy is another factor driving the EUR/USD pair, contributing to further US dollar strength and putting pressure on the euro.

"Eurozone CPI surprised to the upside at 5.8% YoY, but unlike the Fed, the ECB has more cause to mark this down as supply-driven inflation," ING economists said.

"We had been preferring a broad 1.10-1.15 range in EUR/USD this year - after the hawkish turn from the ECB – but the FX options market is warning that the risks to a big break below 1.10 are building," they added.

The euro area consumer price index is projected to rise above 6% in March.

At the same time, ECB officials disagreed on how the regulator should respond to the price surge.

According to economic theory, an increase in the key rate is necessary to cool the economy and reduce inflation. In this case, credit would become more expensive, money circulation would slow down, and price increases would stop.

However, the problem is that in the current environment, an increase in the key rate threatens to reduce GDP growth, recession, and even stagflation.

The euro area Services PMI and PMI Composite indexes for February were revised to the downside.

According to Markit Economics, last month, the first indicator was 58.2 points and the second reached 55.5 points, respectively.

Analysts had predicted that the indicators would remain at the preliminary estimate of 58.4 points and 55.8 points, respectively.

The potential impact of the Russian-Ukrainian conflict on economic growth in the Eurozone is currently estimated in the range of 0.3-1.0%.

ECB Governing Council member and Bundesbank President Joachim Nagel said on Wednesday that the ECB's monetary policy should take into account high inflation.

"If price stability requires it, the ECB Governing Council must adjust its monetary policy course," Nagel said.

At the same time, he noted that it was impossible to assess the economic consequences of the war in Ukraine.

Several ECB officials believe that increased risks are forcing the regulator to act more cautiously.

"The dramatic conflict in Ukraine is now weighing negatively on both supply and demand conditions, making uncertainty more acute and exacerbating risks to the medium-term inflation outlook on both sides. In this environment, it would be unwise to pre-commit on future policy steps until the fallout from the current crisis becomes clearer," Fabio Panetta, a member of the ECB's executive board, said.

"We should adjust policy carefully and recalibrate it as we see the effects of our decisions, so as to avoid suffocating the recovery and cement progress towards price stability," he added.

The futures market expects just under two steps from the ECB to raise rates by 10 basis points in 2022, up from 50 basis points shortly after the ECB's February 3 meeting.

BlackRock experts believe that the Russian-Ukrainian conflict will force the ECB to keep interest rates at zero level until next year.

Unlike its European counterpart, the US Central Bank has already confirmed its intention to raise its key rate by 0.25% later this month.

The Fed's key interest rate hike at its March meeting would be appropriate because of high inflation, substantial demand in the economy and exceptional tightness in the labor market, US Central Bank Chairman Jerome Powell said on Wednesday.

As part of his speech to the U.S. House Committee on Financial Services, he said he would support a quarter-point rate hike when the FOMC meets March 15-16, effectively ending the debate about starting a round of rate hikes after the pandemic with a larger-than-usual 0.5% hike.

At the same time, the head of the Fed stressed that the regulator would be prepared, if necessary, to use larger or more rapid changes in rates, if inflation does not slow down.

This shows the Fed's focus on inflation as a key issue that could undermine confidence in the central bank if things deteriorate, undermining the purchasing power of households and beginning to distort the investment and decisions of businesses and families.

The labor market, as Powell noted in prepared statements, was "extremely tight," and FOMC officials said their goal of maximum employment was effectively met.

According to the head of the Fed, the impact of the pandemic on the US economy appears to be waning, hiring remains strong, and inflation has become a major risk.

Consumer prices in the United States jumped to an annualized 7.5% in January.

According to the report of ADP published yesterday, the employment in the US private sector in February increased by 475,000 against expectations of 350,000. This release is a leading indicator of the key report on the US labor market, which will be issued on Friday and is expected to reflect the growth of employment by 450,000.

Powell acknowledged that the Fed faces new challenges due to recent events in Europe, which could not only increase price pressures but also potentially undermine growth.

"The near-term effects on the US economy of the invasion of Ukraine, the ongoing war, the sanctions, and of events to come, remain highly uncertain," Powell said. He added that the Fed would act to get inflation under control and return prices to the normal state.

After Powell's speech, the futures market began to price in six quarter-point increases in the federal funds rate this year, up from five as of Tuesday.

By the end of the year, analysts expect to see the rate in the range of 1.5-2.5%.

It is assumed that the hawkish policy of the Fed with the inaction of the ECB may lead to a decrease in the EUR/USD pair in the medium term.

As the US dollar slowed its strengthening against the euro on Wednesday, the single currency is still struggling to attract demand as investors refrain from buying risky assets amid ongoing tensions between Russia and Ukraine.

If sellers manage to push the EUR/USD pair below 1.1060, additional losses may be seen while declining towards 1.1000. The Relative Strength Index (RSI) remains below 50, confirming the bear market.

Alternatively, there might be a recovery beyond the weekly resistance at 1.1190, a breakthrough of which may allow bulls to reach 1.1230 and 1.1270.