US Dollar May Rebound vs. Euro as Fed, ECB Policies Diverge

EUR/USD 1Q Forecast: US Dollar May Rebound vs. Euro as Fed, ECB Policies Diverge

The US Dollar soared at the onset of the Covid-19 pandemic as panicked credit markets began to seize up, sending capital scrambling for the reserve currency’s ultimate liquidity. It then turned sharply lower as the Federal Reserve forcefully pushed back, deploying massive stimulus at an unprecedented rate to unclog the pipes and becalm investors.

It appears to have worked: credit spreads narrowed and market sentiment recovered. That this success came at the expense of the Greenback seems to make sense. First, the sheer size of the Fed’s effort exceeded that of other central banks. Second, that markets took this as credible buoyed sentiment and eased haven-seeking USD demand.

This narrative may change as the calendar turns to 2021. While the pandemic continues, economic activity has begun a cautious recovery. It may sputter yet as case growth swells into the winter and a new wave of lockdowns disrupt commerce. Still, October saw the fastest manufacturing- and service-sector growth in over two years.

The markets seem keen to believe that greener pastures are indeed ahead, spurred on by encouraging results for three competing Covid vaccines set to hit the market soon. A clear outcome to the US presidential election and a begrudging resignation to transferring power by the Trump administration have also helped sooth traders’ nerves.

A by-product of this optimism has been a shift away from dovish extremes on Fed policy bets, implying that the central bank may consider pulling back stimulus faster than previously thought. More of the same is likely if current trends bear out. Indeed, priced-in 2- to 5-year inflation expectations have already erased all of their Covid-linked plunge.

One major central bank unlikely to pace the Fed down this road is the ECB. Stubbornly sub-target price growth had the central bank flirting with exotic easing measures like negative interest rates well before the pandemic struck. The structural issues at play there are unlikely to have vanished.

A yawning gap between US and Eurozone breakeven rates underscores this, suggesting that the Euro may turn lower as the global monetary policy pendulum gradually retraces. Technically, early signs of topping may already be emerging at long-term trend resistance. A break back below 1.1880 may trigger an initial leg down toward the 1.16 figure.

EUR/USD Monthly Chart

Chart prepared by Ilya Spivak, created with TradingView

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