Dollar’s Rate Advantage Is Narrowing

As key central bank meetings draw closer, markets appear to favour European currencies to the detriment of the dollar, whose rate advantage is being eroded. The two-year EUR-USD swap rate differential is now the narrowest since August 2020, adding to EUR/USD support.

USD: Soft momentum – Bearish view for now

The week has started with the market leaning again in favour of European currencies and the dollar losing some ground. The price action in short-dated bonds showed a reinforcement of European hawkish bets while the whole US Treasury yield curve inched lower.

Data will be back in focus today in the US, with the Core Durable Goods Orders (MoM) (Mar) expected to have flattened in March Goods Trade Balance (Mar) possibly inching lower.

While a 25bp hike next week by the Fed does not look under discussion, Fed rate expectations have remained rather un-anchored and volatile when it comes to future policy moves. This continues to leave ample room for speculation about Fed Chair Jerome Powell’s tone in terms of future guidance. While data will clearly play a role, recent developments in the US banking sphere are creeping back onto investors' radars. First Republic Bank reported a larger-than-expected drop in deposits in its quarterly results, sparking a new round of heavy selling in the stock after a prolonged period of calm.

This is probably the key thread to follow today: should there be fresh instability in US banking stocks, dovish Fed bets may gather more momentum, and despite its safe-haven status, the dollar could stay on the back foot to the benefit of European currencies backed by hawkish central banks and without an excessively high-beta to sentiment – like CHF, EUR, GBP.

EUR: Narrowing spreads – Bullish view for now

The two-year EUR-USD swap rate differential is now at -65bp, the narrowest since August 2020. The 2020 high is -53bp. We would then need to go back to 2014 (when EUR/USD was trading at 1.20-1.30) to see levels beyond the -50bp mark. While the correlation between short-term rates and the currency pair has been rather unstable and weak of late, this is indeed a factor contributing to a bullish narrative for EUR/USD.

As discussed above, new jitters in the US banking story, as quarterly earnings are released, may hit Fed rate expectations before they are channelled through more structurally defensive trades in FX. EUR/USD could break the 1.1075 14-April highs and find limited technical resistance beyond. Global conditions don’t necessarily point to a higher EUR/USD, but the ongoing momentum in the FX market seems to bring markets closer to European currencies and away from the dollar.

GBP: No domestic drivers – Bullish view for now

It's going to be a very quiet week data-wise in the UK, and the market is fully pricing a 25bp rate hike by the Bank of England in two weeks. I still think that markets are over-estimating the amount of further tightening (71bp in total, including next week’s hike, before reaching the peak), but unless there is a clear push-back by the BoE at the policy meeting, the pound may not lose its solid momentum just yet.

I think that EUR/GBP should trade at 0.90 in the second half of the year, but may hover around 0.8850 for now, while some USD softness may trigger another break above recent highs (1.2543) for cable.

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