ECB-Fed Policy Divergence Underpins EUR/USD

EUR/USD Analysis

The US Federal Reserve was on track to pick-up the speed of its tightening cycle and to hit a higher terminal rate, due to strong incoming economic indicators, but the collapse of the Silicon Valley Bank changed that.

The ensuing financial turmoil led the Fed to a conservative stance as it hiked rates by a small 0.25% and softened its rhetoric, now anticipating that "some additional policy firming may be appropriate". Furthermore, officials maintained the 5.1% median terminal rate forecast, which implies just one more increase, despite upgrading their 2023 PCE inflation forecast and lowering the expected unemployment rate. ^[1]

Although he stressed the uncertainty around the impact of recent events, Chair Powell expects they will likely result in "some tightening in the credit conditions" that could weigh on inflation. More to it, he said that this tightening can be thought as an "equivalent of a rate hike" or even more. ^[2]

The European Central Bank on the other hand, delivered a bigger 50 basis points rate increase last week and even though it refrained from offering forward guidance, President Lagarde pointed out that officials have "a lot more ground to cover" and warned that their determination to fight inflation "should not be doubted".^[3]

In contrast to her US peer, Ms Lagarde drew a clear distinction between the financial stability and price stability, noting that there is no trade-off between the two. In other words, the ECB does not intend to back down from its mandate and pursuit to bring down inflation to the 2% target, because of financial stress.

The ECB's more aggressive stance was evident this week as well, with a series of hawkish speeches by policy makers. Mr Nagel for example, stressed that their job "is not done yet" and that "further interest rate hikes have to follow" if inflation develops as projected. ^[4]

EUR/USD surged after Wednesday's dovish hike by the US Federal Reserve and the divergence with its more hawkish European counterpart is supportive for the pair. With the recent correction having been contained by the 38.2% Fibonacci of the September low/February high advance, the common currency has the ability to set new 2023 highs and tackle 1.1067. However, it may be early to talk for further gains towards and beyond 1.1233.

On the other hand, EUR/USD came under pressure yesterday and further slide could be in play, since the five-day rally was stretched. Such outcome could test the EMA200 (at around 1.0690), but a strong catalyst would be required for daily closes below it, which could cast doubt over the ascending prospects. Sustained weakness past the critical 1.0480-61 region, is hard to justify under the current monetary policy environment.