EUR/USD Key Resistance Test: Fed v/s ECB

EUR/USD Talking Points:

• EUR/USD continues to battle with resistance around the 1.1000 handle despite hawkish commentary from the ECB, reiterated again in the release of meeting minutes from the bank’s most recent rate hike.
• Headline CPI in both the US and Europe have continued to fall and this week showed Eurozone CPI dropping to 6.9% after last week’s US CPI report showed headline inflation at 5.0%. The bigger conundrum at this point is core inflation, which has continued to climb in Europe even as the US has seen some recent moderation.
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The world’s most popular currency pair continues to hold very near a key resistance zone with longer-term importance.

I had highlighted this resistance last month as it was about to come back into the picture. And within an approximate 100 pip area in the EUR/USD pair, from around 1.0930 up to 1.1033, there are multiple forms of resistance at work to create an area of confluence. Three weeks later, and that zone has bent but hasn’t broken in a lasting way, with prices still hovering near the lower portion of that zone as of this writing.

Along the way a rising wedge has built and this is a formation that’s often tracked with aim of bearish reversals, making the continued resistance test all that much more interesting as the bullish trend in the single currency and the EUR/USD pair remains in-play following a six-month rally.

But – what’s behind the move and perhaps more importantly – what might traders be looking for as that next clue as to whether this breaks out or reverses? I’ll dig deeper after this next chart.

EUR/USD Daily Price Chart

The Inflation Conundrum

Ideally, central banks raise or cut rates in a somewhat orderly fashion. The hikes are especially important in this regard because higher rates create reverberations that the rest of the world has to adjust to. Even hikes in the US can bring impact to Europe, especially if the ECB isn’t also lifting rates, as a stronger USD and a relatively weaker Euro can bring on greater inflation to Europe, such as we saw in the first half of last year. And when rates are going up really fast, the impact to the underlying economy can be drastic while exposing vulnerabilities, such as we saw with the recent injection of fear around banking in the United States, which essentially boiled down to an interest rate risk problem.

When inflation is high the central bank has little choice but to address it, as high inflation can lead to even higher inflation, which was, again, illustrated last year in the US. In the first half of last year, even as the Fed had started hiking rates inflation continued to move-higher until eventually hitting its current cycle peak for headline CPI at 9.1% in July. At some point the problem becomes untenable with mere 25 bp increases, much as the United States learned in the 1970’s and this helps to explain why the Fed got so aggressive with tighter policy in June of last year with the bank’s first 75 bp hike in decades.

Given that the Fed began to address this a bit earlier than the ECB, the US appears to be a bit further along in the inflation fight. The below chart highlights headline inflation in the US (blue) against the Eurozone (orange).

US v/s Eurozone Headline CPI Since Jan 2021

Chart prepared by James Stanley

From the above data point, it would seem that both central banks could take a bit of relief from this message, that rate hikes are having their intended effect and that inflation is moderating in the manner that they would want to see.

But if we look at the data a bit deeper, instead focusing on core cpi which strips out food and energy, which is a data point that both the Fed and ECB consider, the matter isn’t so clear.

Core CPI increased in both the US and Europe last month. In the US this was the first such increase since last October. But, in Europe, Core CPI has only continued to increase for the 14^th consecutive month, with only one instance where the data point remained flat month-over-month.

So for the ECB Core CPI still very much remains a problem as there hasn’t yet been any softening in that data point. And last month marked the first instance of Core CPI in Europe outpacing that of the US since February of 2021 when both were at 1.4%. Of particular interest and highlighted in the red box below is the recent rate of change which perhaps not coincidentally syncs with that shift from a bearish to a bullish trend in the EUR/USD pair late last year.

US v/s Eurozone Core CPI Since Jan 2021

Chart prepared by James Stanley

From the above chart both central banks have motive to continue tackling inflation, but that motivation may be a bit greater on the part of the ECB as core inflation has only continued to trend higher even as the US has seen some form of moderation until last month.

This also helps to explain the hawkish drive from various ECB members in the media of late, on top of this morning’s release of meeting minutes from the European Central Bank that indicated support for a 50 bp hike at the bank’s next meeting. Meanwhile expectations around the Fed are indicating a 25 basis point hike at the next FOMC rate decision to be announced on May 2^nd with questions around future hikes from the Fed.

The bigger question around Europe and this speaks to the bank’s initial reticence towards raising rates in the first half of last year, but what might all these rate hikes do to European growth? That doesn’t seem to be much of an issue for the ECB as the fight against inflation takes priority, but if we look at EUR/USD and the continued hold near long-term resistance, the question is worth asking as markets are constantly forward-looking and European rates have been priced-in aggressively since the ECB’s hiking campaign took on new life in Q4 of last year.

EUR/USD Daily Chart

EUR/USD Moving Forward

At this point, fundamentals could support continued Euro strength on the basis of both central bank innuendo as well as the data. But, from the chart above we can see that bulls haven’t exactly been able to run very far above that 1.1000 handle as there’s now been two different resistance inflections over the past couple of months, with the most recent instance helping to build the rising wedge pattern which is often followed with aim of bearish reversals.

In a situation such as this, there’s also the potential for ‘topping’ scenarios. This could take place if a breakout shows, bringing on a fresh high with a test of the 1.1100 level or higher, followed by a quick reversal. This is similar to what happened on February 2^nd with the 1.1000 and 1.1033 levels in EUR/USD. The big question for trend continuation is whether buyers show up to support a fresh high, or whether a run up to a fresh resistance level starts to bring in enough sellers to ultimately shift the shape of the trend, and given the cumulative evidence, that would seem a possibility given the combined technical and fundamental backdrops.

Taking a shorter-term look at EUR/USD and the 1.0909 level remains key for near-term strategies as this is the recent higher-low. If the pair breaks below that, there would also be a test through the support side of the rising wedge which further opens the door for reversal potential.

Alternatively, if the higher-low holds and price re-approaches the 1.1000 psychological level for another test, focus shifts to Fibonacci levels at 1.1033 and then 1.1075. If bulls can force a breach beyond those levels, the possibility of capitulation comes into the picture focusing on fresh highs at potential resistance of 1.1122 and then 1.1185. If that breakout happens quickly, allowing for a topside breach of wedge resistance, the formation can quickly be invalidated which would be a strong showing from bulls, further indicating bullish continuation potential.

EUR/USD Daily Price Chart

--- written by James Stanley, Senior Strategist