Talking to some traders via e-mail, I indicated my medium-term target of Eur-Usd at 1.16 and in this article, I explain the reasons that led me to this conclusion through interest rate analysis.
I start with what is perhaps the most important and most closely followed data in recent months, inflation. I do so by showing you a chart summarising the trend over the past year and a half of inflation in the Eurozone and the United States.
In blue is the inflation in the Eurozone, and in black is that in the US. Two different trends due to two different monetary policies of the two central banks. Powell's is much more aggressive (hawkish), and Lagarde's more wait-and-see. This led to an initial widening of the differential between the two rates with a consequent collapse of the Eur-Usd below parity, touching a minimum of 0.95358 as shown in the chart below.
In red is the yield differential of 10-year Eurozone and US bonds and in black Eur-Usd. You can easily see that the two lines, with the exception of the May/October 2022 period (mostly due to uncertainty about the ECB's monetary policy), are well correlated.
Since a few months ago, since November 2022 to be precise, something has changed and can be summarised by the different inflation trends, as you have seen in the first chart. While in fact in the US inflation is returning to more acceptable levels as a result of the more aggressive monetary policy adopted by Powell with numerous rate hikes, in the Eurozone the situation is not yet at those levels and this could lead Christine Lagarde to remain “hawkish” for longer.
A rate hike of another 50 basis points is expected in May, and it is not certain to be the last. While previously a 4% rate was considered the ECB's monetary policy target, there are now analysts who see rises above that level. However, this 'scaremongering' may also be receding, with the next Eurozone Consumer Price Index (CPI) data due out on Wednesday 19 April, with the preliminary data released at the end of March showing inflation dropping to 6.9 per cent.
In the US, another rate hike of 25 basis points is expected and most likely already at the FOMC meeting on 3 May, as shown by the two charts below.
On the left, you can see the CME FedWatch chart which, at the moment, gives a 78% probability of a 25 basis point rise at the next FOMC meeting and only a 22% probability that rates will remain unchanged. On the right is the spread of the 30-day Fed Funds futures ZQJ23-ZQK23, i.e., constructed by buying the April contract and selling the May contract. Spread confirming a 0.25% rise in US rates in May.
Rise that should be the last, but there is more. Two rate cuts of 25 basis points are expected by December (most likely in the second half of the year) with the US rate expected to end the year in the 450-475 basis point range. Again, using the 30-day Fed Funds futures, you can see how the ZQK23-ZQZ23 spread, i.e., built by buying the May maturity and selling the December maturity, shows just a 0.50 % drop by the end of December.
On the other hand, in the Eurozone, rates are expected to at least rise another 50 basis points, with no hint of future cuts on the horizon. This will bring the two interest rates very close together, resulting in a stronger euro against the US dollar.
This is obviously the current situation. If conditions change in a day, a week or a month, the conclusions could also be very different. To all this, then, a complete macroeconomic analysis has to be added in order to get a correct picture of the two economies.
I conclude with US Treasury Secretary Janet Yellen, who said on Saturday in an interview with CNN that banks may act more cautiously and may reduce lending further in the wake of recent bank failures, possibly negating the need for further interest rate hikes by the Federal Reserve. Yellen also added, “I do think there’s a path to bring down inflation while maintaining what I think all of us would regard is a strong labour market… And the evidence that I’m seeing suggests we are on that path”.
Talking to some traders via e-mail, I indicated my medium-term target of Eur-Usd at 1.16 and in this article, I explain the reasons that led me to this conclusion through interest rate analysis