Short End Yields Down Sharper in EZ Encourages EUR/USD Retracement

The recent rebound of the US dollar over the past four trading days serves as a reminder that foreign exchange rates are relative, influenced by various factors. Although there's compelling evidence suggesting that the Federal Reserve's tightening cycle has concluded and the labour market may be slowing, similar indicators are emerging elsewhere. This has led to renewed selling pressure on non-dollar G10 currencies.

Euro Swap / EURUSD Spot

Source: TradingView

In the latest Reserve Bank of Australia (RBA) meeting, interest rates were held steady, click on this link to have access of a full breakdown analysis on RBA decision.

Prior to the meeting, the Overnight Index Swap (OIS) market implied a roughly 25% chance of a rate hike in February. However, after the meeting failed to signal a strong desire for a hike, this probability significantly decreased. A similar trend is observed in Europe, where weak inflation data and a potential shift in the European Central Bank's (ECB) tone have caused a softening of rates at the front end of the curve. Over the past seven trading days, the 2-year core yield in the eurozone dropped by 46 basis points, while the 2-year US Treasury bond yield decreased by 35 basis points.

EUR02Y

Source: TradingView

US02Y

Source: TradingView

The short-term yield movement favouring the US dollar has prompted a reassessment. This adjustment aligns with my earlier decision to lower EUR/USD forecasts for H1 2024, despite the sharp November rally. I believe it is premature to anticipate substantial gains for EUR/USD.

Looking ahead, Friday holds significance for US rate expectations with the release of nonfarm payrolls data. The recent JOLTs report suggests a potential slowdown in the labour market, with job openings dropping to their lowest since March 2021. This supports the view that increased labour market participation is occurring as US consumers deplete their savings, encouraging a return to work. A potential decline in voluntary job leavers and a stable Quit rate could exert downward pressure on wage growth.

Any further weakness in the labour market, both in the ADP report and nonfarm payrolls, may lead to increased expectations of rate cuts by March, currently implied at around 75%. For the ECB, the probability of a cut in March is nearing 90%, influenced by statements from ECB hawk Isabel Schnabel, who deemed another hike "rather unlikely." Although a cut by March appears improbable to us, there might be pushback during next week's policy meeting by President Lagarde. The upcoming jobs report on Friday, followed by the Fed meeting next Wednesday and the ECB meeting a day later, could introduce heightened volatility. If short-term spreads remain within their recent range, a further retracement in EUR/USD could be on the horizon.

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