2 Reasons Why EURUSD Can Deep Further

Throughout this month, I've noticed that the Euro (EUR) has been undergoing a consolidation phase at relatively lower levels in comparison to the US Dollar (USD). After reaching an intraday low of 1.0448 on the 3rd of October, the EUR/USD exchange rate has subsequently rebounded towards the 1.0600-level. I believe the recent weakening of the USD can be attributed to a shift in sentiment from Federal Reserve (Fed) officials. They have expressed concern regarding the rapid adjustments observed in US market interest rates. The 10-year US Treasury yield, which stood at approximately 3.50% in April and May, has now reached a new cyclical high of 4.89% this month.

I've observed that Fed officials are now indicating a decreased willingness to proceed with their plans for a final interest rate hike this year if US market rates persist at elevated levels. The significant tightening of financial conditions in the United States has, in a way, acted as a natural brake on economic growth and inflation. Currently, the US economy continues to display resilience and is on track for robust expansion of around 4% in the third quarter. Nevertheless, I anticipate a period of economic weakness in the fourth quarter. Factors contributing to this anticipated weakness include the resumption of student debt repayments and the looming risk of a government shutdown after the 17th of November, both of which could further hinder growth momentum as the year draws to a close.

My expectation is that the Federal Reserve will maintain the status quo by keeping interest rates unchanged at the upcoming Federal Open Market Committee (FOMC) meeting scheduled for the 1st of November. I may, however, leave the door open for a rate hike in December, an outcome that is already largely factored into the expectations of the US interest rate market.

In contrast, I find the fundamental backdrop challenging for the EUR in the near term. The relative underperformance of the euro-zone economy has become more marked in Q3. It could be confirmed in the month ahead that the euro-zone economy contracted again in Q3, and I see little evidence, yet that growth momentum is starting to pick up heading into year-end. With building evidence of slowing inflation in the euro-zone, I'm becoming more confident that the ECB's rate hike cycle has already ended. I expect the ECB to leave rates on hold at our next meeting on the 26th of October. My policy discussions could focus more on ways to tighten policy through measures to tighten liquidity or speed up the pace of balance sheet reduction. Reports have suggested recently that the ECB is considering tightening liquidity through raising the number of minimum reserves banks need to hold at the ECB. With little priced in for further ECB hikes and the ECB unlikely to encourage expectations for rate cuts, our upcoming policy meeting should have only a modest impact on EUR performance.

External developments could prove a more important driver of my EUR/USD performance in the month ahead. For most of this year, EUR/USD has traded within a relatively narrow range between 1.0500 and 1.1000. The main risk of the pair moving closer to parity would be if geopolitical risks in the Middle East continued to intensify. While I expect the conflict between Hamas and Israel to remain contained, a broader regional conflict could trigger a sharper adjustment higher for energy prices and result in a weaker EUR. To better capture this risk, I am shifting my bias for the EUR/USD to bearish from natural. On the positive side for the EUR, there has been more evidence that economic growth in China is picking up heading into year-end, which is helping to ease another downside risk that has been weighing on the EUR over the summer.

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