Summary:

• EURUSD dips below 1.18, the lowest this year
• Diverging monetary policy and inflation among prime reasons for the decline
• Italy added a burden on the euro
• Technical analysis sees a strong short term downtrend, the key support at 1.1550

The EURUSD saw the 2018 low of 1.1770 on Wednesday. Here we provide 5 reasons behind this decline, analyse outlook and present technical analysis.

Diverging monetary policy

Major currencies often follow interest rates quite closely and it was the case with EURUSD for years. 2017 was a major puzzle for FX investors as widening bond spread in favour of the US dollar was met with depreciation. However, investors could not dismiss rising US market interest rates forever and we can see on the chart that this factor greatly contributed to a steep decline on the EURUSD.

EURUSD has been tumbling on the back of higher US market interest rates. Source: Bloomberg, XTB Research 

Inflation prospects

The CPI inflation in the US is nearly double of that in the EMU and this decouple may increase further in coming months. This has investors speculating that the Fed could increase rates 4 times this year while the ECB still purchases government bonds. Furthermore, while the EU recovered strongly last year this recovery has stalled somewhat into 2018 and the US economy seems to be more resilient.  

US inflation is double of that in the EMU – a fine reason behind a lower EURUSD. Source: Macrobond, XTB Research

Rising oil prices

The OPEC policy, the Venezuelan crisis and now a break of Nuclear Deal with Iran – all these factors see the oil prices on the rise towards $80. Higher oil prices are literally fuelling inflation and while this happens everywhere investors think that the Fed is more likely to react as it’s in the midst of monetary tightening anyway while the ECB is widely expected to stay put until the end of this year.  

Italian concerns

Italy has been somewhat forgotten by the markets even though it had no government for the past 10 weeks. Now the government could be in place but populist from the League and the M5S could very well revive the demons of the eurocrisis through their demands. They have already poured some cold water on the markets suggesting a write-off of Italian bonds purchased by the ECB and relaxation of (already modest) fiscal discipline at home. Let us recall that the Italian 10-year bond yielded more than 7% few years ago – a level that is clearly unsustainable for Italy – and shrunk to 2% only because of massive purchases by the ECB.  

Investors’ positioning

Speculative investors were historically net long on the euro and at the same time net short on the dollar at the beginning of this year and now that the circumstances have changed this positioning might need to be adjusted.

What’s next?

While Italy is a serious long term concern we do not expect it to have a massive short term impact. The real question is: could bond yields keep diverging between the US and Germany? We are not so sure. Yes US inflation will be higher but these conditions will eventually bite into the US growth as well and the Fed may be reluctant to overdo the tightening. Secondly, recall that US bond yields looked far more attractive last year and yet the US dollar kept sliding because of the “Trump factor” (weak dollar talk, reform disappointments and various scandals). With the US dollar gaining on all the fronts it could be also a matter of time before we hear again from Trump (accusing Europe of “artificially weakening its currency”). Therefore we do not look at the current decline as an actual trend reversal.

Technical analysis

EURUSD, W1 – the pair cracked through the 50 and 75 week average placing an upwards trend at risk. What we see is a corrections that’s been already stronger than the one from late 2017 and has more momentum (5 bearish candles in a row). The key level to watch is 1.1550 that used to be a very strong resistance in the past and now could act as a vital support. The key resistance is at 1.20.

EURUSD, H1 – on a lower interval we see a very persistent downwards trend. It can be well encompassed by moving average and we could see that the pair reacted a lot to the area between 75 and 150 LWMA and kept moving south.