EUR: Navigating a Well-Justified Correction Amid Divergent Monetary Policies

EUR: A well-justified correction

EUR/USD performed quite strongly during the holiday period, touching 1.11 on 27 December. The post-correction levels around 1.0950 are, however, more in line with the short-term rate differential. We must remember that the rise in Fed dovish bets was matched by European Central Bank rate cut speculation, and the diverging narratives expressed at the respective December monetary policy meetings did not really change the short-term rate picture.

The EUR-USD 2-year swap rate gap remains around 125bp, close to the lows for 2023. EUR/USD detached from its short-term rate dynamics in November/December, as dovish Fed bets fuelled a big rally in equities and the risk-on environment had an asymmetrical impact on the pro-cyclical EUR. However, dwindling risk sentiment definitely puts EUR/USD at risk of reconnecting with its depressed short-term rate differential, especially considering domestic economic news in the eurozone has remained rather grim. We think EUR/USD continues to face downside risks, and a return above 1.10 appears less likely than a decline to the 1.08 region. This week, the focus will be on inflation numbers for December: France and Germany’s numbers are released tomorrow, with the eurozone figures on Friday.

EUR/GBP climbed back close to the 0.8700 mark in late December, and while we still expect a capitulation of the Bank of England's higher-for-longer narrative to hit the pound this year, the short-term outlook remains rosier for GBP than for the euro. A return to 0.8600 is possible before a clearer appreciating trend emerges.