… the key question is: will there first be a more pronounced break in parity, before it bottoms out?
Calling the EUR/USD low was no fun for anyone who tried it. Fortunately, we have always been bearish on the most traded currency pair in the world. But at these levels, even we need to at least entertain the idea of a potential bottom.
So, how likely are we to see a low around parity on the EUR/USD exchange rate?
There’s no short answer, but there are good reasons why a bottom for EUR/USD could be near, if we haven’t already seen it.
The euro too cheap?
First, there is the argument that the single currency may have become too cheap.
Remember that the euro was last this weak in 2002. Even at the height of the pandemic in 2020 or the European debt crisis in 2012, it was not this low.
This time, we are talking about stagflation and a strong divergence between the monetary policies of the United States and the euro zone. So there is a good reason why EUR/USD is where it is this time around.
But unless this economic downturn turns into a prolonged recession or depression, the market may underestimate the value of the single currency.
Recession risks in the United States are not taken into account for the USD
We are likely to be already in recession in Europe, hence the weakness in the single currency and equity markets. But the U.S. could follow suit with all those aggressive rate hikes and growing inflationary pressures weighing on consumer sentiment and spending. The global slowdown could very well push the world’s largest economy into a recession.
As we saw on Wednesday, the US CPI was much warmer than expected at 9.1%, which spurred speculation that the Fed would press on the metal and offer a 100 basis point rate hike at the instead of 75 at its next meeting. This only raises concerns about an economic downturn. The Fed’s anticipated interest rate hikes only advance the rate cut cycle. The markets believe this could happen as early as the first quarter.
But could EUR/USD fall below parity before seeing a bottom?
This was my base case scenario, and we already saw the Euro print below 1000 on Wednesday, before recovering over 100 pips. Was it that, or will it drop back below parity, and this time more decisively…. leading to capitulation and an eventual dip?
This scenario cannot yet be ruled out. Remember that just a few days ago the market fully priced in a July 75 basis point rally. The CPI overshoot and BoC’s larger 1% rise raised the bar and investors began betting that the Fed will now also rise 1% instead of 0.75% in two weeks. The OIS market was forecasting a 90 basis point rise for July on Thursday morning when this report was written.
From my observation of large round handles and after many dips, I think there will be plenty of speculators looking for a EUR/USD bounce around the pair. On Wednesday we got a 100 pip bounce before rates moved back down to 1.2020 at the time of writing.
I expect to see more such bounces as speculators take profits on their shorts or opportunistic bull traders look for “one-shot-one-kill” types of bounce trades whenever we get closer. of parity. Whether or not we will see a bigger rebound than the day before remains to be seen.
But the logic of bulls can be something like:
“I want to go long around current levels with a stop not too far below parity to get a good reward-risk profile. If it works out great, if not well then it was a calculated risk. Maybe I would start with a small position to test the waters, then later if we see more signs that he wants to bottom, add to that position so I have full 1R risk.
In a word
The ongoing reassessment of Fed rate expectations is likely to keep the dollar supported and could lead to another break below parity in the coming days. Even so, for the reasons stated above, I think we are very close to bottoming out on EUR/USD. Whether the parity breaks again or not, I think the downside risks are limited for the euro in the future.