FX Daily: Trans-Atlantic Divergence Keeping EURUSD Bid

EUR/USD remains close to the highs of the year as a Fed pause and simmering banking crisis cut the dollar's short-term yield advantage over the Euro. Yesterday we saw a 25bp ECB hike and it is now probably stretched positioning which is the biggest headwind to further EUR/USD gains.

USD: That's all folks: Bearish View

Dollar was only slightly weaker at the end of Chair Jerome Powell's press conference and the US yield curve had barely budged on the news that the Fed was shifting to a meeting by-meeting approach to monetary policy setting. However, in the final few hours of US equity trading, US regional banks - especially PacWest - came under renewed pressure on reports that PacWest was 'exploring options'. Given that First Republic equity and bondholders were wiped out this week, that clearly caused some concerns. The point here is that the 15bp decline in US two-year yields overnight seems to have been driven by the banking crisis - not the Fed commentary.

Nonetheless, the dollar's yield advantage continues to dwindle, leading to some modest weakness in the DXY - now down around 0.5% on the week. The nature of the decline in US yields has relevance for the FX market as this is not the kind of benign dollar decline that benefits all currencies. Those currencies with the highest correlations to US equities look more exposed (e.g., the commodity currencies of the Canadian and Australian dollars), while the least correlated - such as the Japanese yen and Swiss franc should outperform. This would be our near-term preference given that the US banking crisis is showing no signs of slowing. This also raises the question of what US policymakers can do here with an increasing focus on whether the FDIC can somehow increase deposit insurance coverage - at least for transactional or business accounts. Watch this space.

For today, a lot of the focus will be on the big data with the April nonfarm payrolls report released tonight. Overall expect DXY to stay soft - unless we start to see any dislocation in US money markets again such as a sharp widening in the Euro cross-currency basis swap or a much higher FRA-OIS money market spread. The DXY year low is around 100.75/80, below which 100 beckons.

EUR: Positioning is probably the biggest headwind to EUR/USD: Neutral View

EUR/USD remains close to the highs of the year - but has yet to take out the 1.1100 level.

The ECB rose rates by 25bp (taking the deposit to 3.25%) and the language remain quite hawkish given sticky core inflation. Markets price, after yesterday, two further 25bp rate hikes into October - at a time when the market is also pricing Fed cuts. This is helping to narrow two-year EUR:USD swap differentials. At 65bp in favour of the dollar these are at the narrowest levels of the year and EUR/USD supportive.

There is a risk that the hawkish ECB sends EUR/USD through 1.1100, but a) long positioning is quite stretched and b) a hawkish ECB is priced. This warns that EUR/USD could hang around this 1.10 area a little longer - particularly were the US equity sell-off to gain momentum. Also, watch out for how EUR/USD trades after the 16CET FX options expiry today. There is some talk that an FX options barrier is being protected at 1.1100.

GBP: Softer dollar helping GBP/USD: Neutral View

One could be forgiven for thinking that there has been a major re-appraisal of sterling now that GBP/USD is trading closer to 1.26. In fact, this is mostly a dollar move and trade-weighted sterling has not moved much this week. It seems that the view that European banks, including the UK, are better regulated than those in the US is providing some insulation to European currencies. This is also helping to keep expectations alive (expectations with which we disagree) that the Bank of England can hike rates two to three more times this year. Our latest views are that the BoE may not push back against these expectations next week - which would see sterling hang onto recent gains. Expect EUR/GBP to remain steady (slight upside bias) near 0.8800, while GBP/USD could trade up to 1.2650/2750 - should EUR/USD manage to break through 1.1100 with momentum.

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