EUR/USD rebounds sharply, eyes 1.1300 level, as global dovish central bank repricing hits dollar

• EUR/USD rebounded sharply on Friday to just below 1.1300 and is set for its best day since May.
• Dovish repricing in global central bank expectations has hit the hawkishly priced USD harder than the comparatively dovishly priced euro.

EUR/USD has rebounded sharply on the final trading day of the week amid a spike in broader market volatility owing to concerns about a new, potentially vaccine-resistant, Covid-19 variant in South Africa. The pair has rebounded to just below 1.1300 from early Friday Asia Pacific session lows just above 1.1200, a near 90 pip (roughly 0.8%) rally on the day. If the pair closes the week out at current levels, that would mark its best one-day performance since early May.

Some traders were perplexed by the pair’s strong performance. Typically, the US dollar is seen as more of a safe-haven asset than is the euro, so why is the euro outperforming the dollar by such a significant degree on a day characterised by risk-off flows?

Why the upside?

Some FX strategists said that the latest Covid-19 developments had encouraged market participants to take profit on short-euro positions, with the euro (before this Friday) heavily oversold. It is true that, until Thursday, EUR/USD’s Relative Strength Index score was 26.62, below the 30 level that technicians view as signifying oversold conditions.

But the story of euro outperformance versus the US dollar likely has more to do with an adjustment of central bank policy tightening expectations. In recent weeks, central banks have been a key driver of FX markets. Fed tightening expectations had been being brought forward amid strong US data, high inflation and hawkish Fed speak, benefitting the buck, while the ECB maintained a more dovish stance and the outlook for the Eurozone deteriorated amid rising Covid-19 infection rates.

If a nasty new Covid-19 variant does spread globally and damages the global economic recovery, this thus leaves the US dollar more vulnerable to a dovish repricing in Fed policy expectations than it does the euro. This seems to be the view of USD and EUR short-term interest rate markets on Friday.

Money market repricing

The December 2022 three-month eurodollar future (a proxy for where markets expect the Fed funds rate to be next December) jumped 17 points to 99.10 on Friday. In other words, markets reduced their Fed tightening expectations for 2022 by 17bps. Meanwhile, the December 2022 three-month Euribor future was up a much more modest 3 points to 100.38, though this was it highest in over a month.

Given that the December 2022 eurodollar future was trading at 99.50 as recently as the start of October, there is plenty more room for upside if the Covid-19 situation in the US deteriorates in the coming months. This would present as an upside risk to EUR/USD.