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EUR USD - FUNDAMENTAL DRIVERS

OANDA:EURUSD   Euro / U.S. Dollar
EUR

FUNDAMENTAL BIAS: BEARISH

1. Monetary Policy

Less dovish than expected can some of the ECB Dec pol decision. As expected, the bank announced that PEPP will discontinue from March 2022, but they announced a surprise decline monthly purchases under the APP, which will see purchases increased to EUR 40bln from EUR 20bln from2Q22 and then subsequently lowered to EUR 30bln in Q3 and down to EUR 20bln in 4Q22. Markets were not expecting any reduced purchases under the PEPP, so expecting the APP amount to return to EUR 20 billion by end next year was less dovish than expected. On inflation there was no surprises with updated staff econ projections showed 2023 HICP at 1.8% which reiterated the bank’s view that inflation will return to below target in the med-term . President Lagarde struck a familiar tone regarding rates by reaffirming that rates are unlikely to rise next year. As usually ECB sources provided more colour after the meeting by showing further disagreements among the GC regarding with the hawks unhappy with extending PEPP reinvestments to 2024 and not setting an end-date to the APP, and of course disagreed that inflation risks as skewed higher. Overall, the bank was less dovish than expected but the stark policy divergence between the ECB and the likes of the Fed and BoE means the bias for the EUR remains tilted lower in the med-term .

2. Economic & Health Developments

Even though the recent activity data suggests the hit to the economy from previous lockdowns weren’t as bad as feared, the massive climb in case numbers across Europe (including Omicron cases) have seen more restrictive measures which will drag on growth. Further lockdown measures will probably see a further divergence in growth differentials between the EU and other major economies (and combined with ongoing central bank policy divergence) the fundamental outlook remains bearish for the EUR. On the fiscal front, attention is still on ongoing discussions among EU states to potentially allow the purchase of green bonds NOT to count against budget deficits. Such a decision could drastically change the fiscal picture and we would expect it to be a big positive for the EUR and EU equities if that change should come to pass.

3. Funding Characteristics

As a low yielder (like JPY & CHF), the EUR has been a funding choice among carry trades, especially during 2019 where it was a favourite against high yielding EM. Also, part of the EUR upside in the initial risk-off scare in March 2020 was attributed to an unwind of large carry trades. Recently the EUR has exhibited some resilience during risk off tones. As more central banks start normalizing policy, the EUR’s use as a funder could add additional pressure in the med-term . But it could also spark risk off upside if some of those trades unwind.

4. CFTC Analysis

Latest CFTC data showed a positioning change of +5080 with a net non-commercial position of -1554. Even though positioning isn’t stretched on the large speculator side, it’s a different story for leveraged funds which is still sitting on the biggest net-short for the majors. That means watching key technical levels to the upside such as 1.1380 for possible squeezes will be important in the week ahead.


USD

FUNDAMENTAL BIAS: BULLISH

1. Monetary Policy

A lot more hawkish than expected is how the Fed’s Dec decision can be summed up. The Fed doubled the pace of tapering to $30 billion per month which will see the QE program conclude by March 2022 as was widely expected. The big change came from the updated Summary of Econ Projections where the median dot plot pencilled in 3 hikes for the Fed next year (up from just shy of 1 hike projected just 3 months ago), confirming money market and Fed Fund Future expectations. Fed Chair Powell explained they hadn’t decided whether to pause between the end of tapering and a first hike but reiterated that rates will likely only rise when the taper has concluded. Another positive shift was Powell’s comments that the balance of goals means it could possibly raise rates before full employment has been met due to high inflation , and also stated that with inflation above target, they cannot wait too long to get to maximum employment with current levels of inflation described as a threat to full employment. The hawkish tilt even went so far that the bank started to discuss the balance sheet but said they didn't make any decisions on when the balance sheet would shrink. Even though the dots projected 3 hikes for 2022, the updated rate hike trajectory only showed 1 additional hike over the forecast horizon, which combined with a lower terminal rate was less hawkish than some had feared. Nonetheless, with this recent meeting the Fed is now the second most hawkish CB after the RBNZ and should be supportive for the USD in the med-term .
This past week’s meeting minutes also revealed that the bank has started discussing QT with majority of members thinking it’s appropriate to start QT soon after rate lift off which was a much more hawkish tilt than expected from the Fed.

2. Real Yields

With the hawkish tilt from the Fed, it should see breakeven inflation rates fall faster than US10Y as a more aggressive Fed should see med-term growth & inflation expectations fall. Rising real yields should be good for the USD as well and one to keep on the radar, especially after this weeks divergence.

3. Global Risk Outlook

What happens to growth and inflation this year will be key for the USD, not only growth and inflation in the US though but also on a global scale. The USD usually does bad in reflationary environments (where growth and inflation accelerates globally), while the USD usually does very well when growth and inflation decelerates globally). So, expectations that we are seeing a slowdown in both of them globally should be a positive input for the USD in the med-term . However, it also means there will be a lot of focus on the incoming data to see how it develops.

4. CFTC Analysis

Latest CFTC data showed a positioning change of +2289 with a net non-commercial position of +39078. With large specs net-longs close to 2019 highs and leverage funds USD longs also looking stretched, and with a lot of the Fed hawkishness arguably priced in, the USD has been looking vulnerable to some unwinding, which is what we saw this past week. Even though the Fed remains on a hawkish path (for now) and the USD remains bullish from a fundamental outlook point of view, with positioning where it is right now, any recovery in risk sentiment or bad economic data in the US relative to the rest of the world could continue to add some pressure on the Greenback in the short-term. However, it will take a lot to change the overall fundamental bullish outlook given what markets are expecting from 2022.

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