ECB decision time: For FX, the euro’s in need of a hawkish tilt as downside risks mount

The Omicron impact on markets initially offered some support to the euro, as EUR-funded popular carry trades (short EUR/RUB is a notable example) were quickly unwound amid risk-off and falling oil prices. With markets quickly reverting their bearish bets and now looking less concerned about the new variant, EUR/USD is looking at fresh downside risks.

An additional factor weighing on the EUR recently is the re-rating of eurozone growth expectations due to restrictions in Germany and other EU countries. From a forward-looking perspective, markets seem to be pricing in a greater likelihood of tough containment measures in Europe than in the US and this keeps widening the US-EZ growth and monetary policy differential. The short-term rate differential has shown a high beta to EUR/USD in 2021 according to our short-term fair value model and has been a major contributor (along with relative equity performance) to the recent EUR/USD weakness.

This should mean that EUR/USD may prove asymmetrically more sensitive to any hawkish surprise, whether that be on the timing of unwinding asset purchases or on staff projections), compared to signs of extra cautiousness. If, instead, we see no major surprises by the ECB, and given the Fed meeting risks prompting another spike in US short-term yields, we think EUR/USD may be set for another bad week. After all EUR/USD is slightly overvalued according to our short-term fair value model, suggesting there is still room for the pair to catch up with the unfavourable widening of USD-EUR short-term rates.

From a technical perspective, net speculative positioning on the EUR has declined of late, but, unlike some other G10 currencies, it is not in over-stretched net-short territory, as you can see in our chart below.