Euro/Dollar ‘significantly’ undervalued, Fed rate hike could help close the gap

  • Undervalued EUR/USD shows analysis
  • Euro better supported in Ukrainian headlines
  • The Fed will raise rates on Wednesday
  • USD tends to underperform after the first rise

Image ©Adobe Images

The dollar has traditionally tended to lose value after the Federal Reserve launched its first rate hike of the cycle studies, which could help a pressured exchange rate between the euro and the dollar to recover.

Indeed, the Fed’s interest rate hike comes amid high geopolitical tensions caused by the war in Ukraine, which just means that this time is different from previous times.

“There is notable value in the EUR assuming geopolitical tensions are about to ease. EUR-USD is trading well below the levels implied by the rate differential (2Y 1M for example, a discrepancy that could be attributed to political risk,” says Daragh Maher, head of research, Americas, at HSBC.

Euro Dollar vs. Rate Differentials

Above: “EUR-USD Looks Weak Against Credit Spreads” – HSBC.

The euro was one of the big losers when Russia invaded Ukraine and sent gas prices soaring in Europe, but the initial shock of the invasion now appears to have been largely absorbed by financial markets.

Of course, war is brutal and unpredictable and it is too early to make concrete calls accordingly.

“The euro’s inability to hold onto its initial gains likely partly reflects the fact that the negative risk premium built into the euro due to the Ukraine conflict remains the main driver of near-term performance. “There is no clear evidence that the Ukrainian conflict is – the escalating euro will struggle to stage a lasting rebound,” says Lee Hardman, currency analyst at MUFG.

Ukraine and Russia continue to negotiate and as of this writing we note some positive noises: “Volodymyr Zelensky says Russian peace talks seem more realistic”, reports The Telegraph.

And in a nod to Russian demands, Zelensky said it is highly unlikely that his country will join NATO, fulfilling a key request from Russia.

The euro-dollar exchange rate could recover further if the markets take into account the worst of the current episode.

Market attention will almost certainly turn to the issue of Federal Reserve rate hikes should Ukraine become less of a pressing issue.

Indeed, today represents an important milestone for global markets as the Federal Reserve will raise interest rates and signal the start of its normalization process, but it will be guidance on the outlook that will have the most impact. on the dollar.

  • EUR/USD reference rate on publication:
    Spot: 1.0980
  • High bank rates (indicative band): 1.0596-1.0672
  • Payment specialist rate (indicative band): 1.0880-1.0903
  • Learn more about rates and service that beat the market, here
  • Set up an exchange rate alert, here

The decision to raise rates by 25 basis points and associated guidance will come at 18:00 GMT, when volatility in dollar exchange rates could spike.

The market has been braced for a 25bp rally for some time, so that in itself is unlikely to shake the tree.

Already this week, the yield on US 10-year bonds is back to its highest level since July 2019, and US interest rate futures are now 175 bps tighter this year from 120 bps a year ago. two weeks.

The changing dial on future bulls will most likely be where the interest in the forex markets lies.

“For this Wednesday, if we don’t see the dots reflect at least 5 ups for this year, I suspect the USD is hit,” said Bipan Rai, head of North American currency strategy at CIBC. Capital Markets.

The “points” he refers to are the set of projections that each voting member of the Federal Open Market Committee (FOMC) plots to determine where they see the base rate band going forward.

Dot plots December FOMC

Above: “FOMC participants’ assessments of the appropriate monetary policy: midpoint of the target range or target level of the federal funds rate” – Source: Federal Reserve.

Secure a retail exchange rate between 3 and 5% higher than that offered by major banks, learn more.

If the points rise, the market will accordingly price in more rate hikes, which could boost the dollar.

But the outlook is already bright, and some currency strategists are unsure that the Fed can really go much more hawkish, potentially leaving dollar exchange rates exposed to a downside reaction.

“The market will watch the points. And these SHOULD change from what was announced in December (3 rises by the end of 2022, 3 for 2023 and 2 for 2024). The market is valuing more than 6 for this year, followed by 1-2 for next year,” says Rai.

Brent Donnelly, CEO of Spectra Markets, says he is looking to sell the dollar on the first rate hike.

Donnelly, a market veteran who previously traded currencies for HSBC, says that “history says sell dollars in the first Fed rate hike. It’s a sample of four, so clearly not a statistical truth or anything, but logical. It’s classic ‘buy the rumour/sell the fact’.”

Above: The dollar index 250 days before and 250 days after the first Fed hike. – Spectra Markets.

And another chart used by Donnelly suggests heading into the first rate hike of 2022 shows the dollar showing very similar patterns to previous events:

USD Performance vs. Average

Above: The same graph as above, but this time on average. It shows that a similar pattern is underway in 2022. Image: Spectra Markets.

Ahead of the FOMC event, the euro-dollar exchange rate is expected to trade at 1.0977, near its lowest levels since November 2020 and extend a medium-term downtrend that has taken root since May 2021.

The market pushed the euro lower against the dollar largely in anticipation of a quick series of rate hikes from the Federal Reserve that will certainly come faster than those from the European Central Bank.

However, this theme has been around for quite some time and is well understood by the market.

Euro bulls are therefore hoping that the momentous occasion for the Fed’s first hike of the next cycle is when there is a material change in the fortunes of the euro-dollar.

Derek Halpenny, head of research at MUFG, also identified the historic downward trend in the dollar after the first rate hike, but warns this time could be different.

He says the strong US dollar momentum in this first rate hike reflects Russia’s invasion of Ukraine.

“This implies an element of difference in terms of comparison to previous rate hike cycles and therefore suggests that the US dollar is likely to remain supported for longer than the previous three cycles illustrated below,” Halpenny said.

Previous DoorDash: Announcing Gas Rewards Program for Dashers to Offset Rising Costs at the Pump
Next How private equity boosted various links in the value chain