Until recently investors had almost no doubt that the Federal Reserve (Fed) was close to the quantitative easing cycle, while expecting the European Central Bank (ECB) to raise its interest rates to lower roaring inflation in the Eurozone. That supported the Euro and put some pressure on the U.S. Dollar.
The situation is changing, however. Eurozone April inflation has slowed down to 0.6% month-on-month vs 0.7% estimate and 0.9% MoM in March. Inflation rose to 7.0% YoY meeting consensus of 6.9% in March. Such a combination is not a very favourable mix to enable the ECB to press on with rising interest rates. More importantly, the Core Consumer Price Index (CPI), cleared from energy and food prices, was down to 5.6% year-on-year vs 5.7% in March. This is of utmost importance as fuel has been a primary driver for rising inflation over the last few months. The slowdown of Core CPI demonstrates falling fuel prices that came under pressure amid recession fears.
Crude prices have fallen even lower in May as Brent crude slid below $78 per barrel from $87.4 per barrel in the middle of April. TTF Gas prices dropped from April highs at 51.78 Euro per MW to 30.87 Euro per MW on May 18. These levels were last seen before 2022. Prices drop not only on recession fears, but amid gas saving measures in Europe and rising gas reserves. Gas inventories in Europe were at 64.1% of the capacity, which is 60% above the same period levels last year. Thus, a further slowdown of core inflation might be expected to drag headline inflation down too. This trend will limit opportunities for the ECB to further hike interest rates.
The suffering European economy is also limiting such intentions, as industrial production in the EU fell by 4.1% month-on-month in March after rising by 1.5% MoM in February. First quarter GDP edged up by 0.1% compared to 0.3% in the Q4 2022. ZEW economic sentiment index for the EU dived into negative territory in May to -9.4 points from 6.4 points in April. All this put additional pressure on the single European currency as a risky asset flagging the ECB not to go further with its monetary tightening.
The Dollar is a safe haven asset and is expected to play this role during a recession too. Ironically, there are even some minor chances for a U.S. government debt default to also support the Dollar. The default scenario is not very realistic, but is also considered by investors. In case of a default, Treasuries prices may plunge, while yields may sky-rocket. This will make investments in U.S. debt extremely attractive.
In the likely scenario that the U.S. debt ceiling is raised, the Dollar is unlikely to suffer as this outcome is widely expected. Borrowing will rise as the U.S. Ministry of Finance will finally have the opportunity to resume borrowing to pay government bills. This may eventually lead to a rising debt yields and it could point to the Dollar as being a good buy opportunity in any scenario.
Technically, it would be important for the EURUSD to drop below the 1.0790-1.0800 strong support level. In case of a breakthrough, the Euro may tumble to 1.0700-1.0740. The resistance is now at 1.0870-1.0920.
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