- EUR / USD rallied sharply on Friday just below 1.1300 and is the best performer since May.
- The moderation in the expectation of a rate hike by central banks has affected the aggressive dollar more than the euro with more moderate prospects
The EUR/USD It has recovered sharply on the last trading day of the week amid an increase in market volatility due to concerns about a new, potentially vaccine-resistant variant of Covid-19 in South Africa. The pair has recovered to just below 1.1300 from Friday’s Asian session lows above 1.1200, a rally near 90 pips (roughly 0.8%) on the day. If the pair closes the week at current levels, that would mark its best daily performance since early May.
Some traders were stumped by the pair’s strong performance. The US dollar is generally considered more of a safe-haven asset than the euro, so why is the euro outperforming the dollar to such a significant degree on a day characterized by flows of risk aversion?
Why raise it?
Some currency strategists said the latest Covid-19 developments had encouraged market participants to profit on short euro positions, with the euro (before this Friday) heavily oversold. Admittedly, as of Thursday, the EUR / USD Relative Strength Index score was 26.62, below the 30 level that technicians see as oversold conditions.
But the story of the euro’s outperformance against the US dollar probably has more to do with a tightening of central bank policy expectations. In recent weeks, central banks have been a key driver of currency markets. The Fed’s tightening expectations were already secured amid strong US data, high inflation and aggressive language from the Fed, which benefited the dollar, while the ECB maintained a more dovish stance and outlook for the Eurozone deteriorated amid rising rates of Covid-19 infection.
If a nasty new variant of Covid-19 spreads globally and damages the global economic recovery, this leaves the US dollar more vulnerable to a moderate revaluation in Fed policy expectations than the euro. This appears to be the sentiment of the USD and EUR short-term interest rate markets on Friday.
Money market appreciation
The Eurodollar future three months to December 2022 (an indicator of where markets expect the Fed funds rate to be next December) jumped 17 points to 99.10 on Friday. In other words, markets lowered their 2022 Fed tightening expectations by 17 basis points. Meanwhile, the future Euribor three months from December 2022 rose 3 points to 100.38, although this was the highest level in more than a month.
With the December 2022 Eurodollar future trading at 99.50 as recently as early October, there is much more room for the upside if the Covid-19 situation in the US deteriorates in the coming months. This would present itself as a bullish risk for the EUR / USD.
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