EUR/USD stabilises under 1.1350 with eyes on widening US/Eurozone yield spreads

• EUR/USD has stabilised just under 1.1350 on Wednesday after Tuesday’s sharp yield differential widening fuelled drop from above 1.1400.
• With market participants expecting the ECB’s transitory inflation call to prove correct but upping hawkish Fed bets, EUR/USD risks further downside.

After Tuesday’s sharp downside that saw EUR/USD shed as much as 0.7% (its worst day since January 3) and slide from above 1.1400 to as low as the 1.1320s, the pair is stabilising just under 1.1350 on Wednesday. At current levels near-1.1340, EUR/USD is up about 0.1% on the day and for now seems content to range close to the 21 and 50-day moving averages at 1.1343 and 1.1324 respectively. Traders attributed a sharp rise in long-term US/Eurozone bond yield spreads on Tuesday which saw the US 10-year’s rate advantage over the German 10-year hit its highest levels since late-November above 188bps as weighing on the pair. Ahead, it should be a reasonably quiet session with just US Building Permits data at 1330GMT worth noting.

Much attention was made of German 10-year yields surpassing 0.0% for the first time since May 2019 on Wednesday and indeed, the US/German 10-year spread is unchanged in the 188bps region on Wednesday, suggesting that EUR/USD consolidation is appropriate. But heading into next week’s Fed meeting which is unanimously expected to be a hawkish affair, EUR/USD traders will be keeping an eye on whether the US/German 10-year spread can rally further to test November highs above 192bps which could coincide with EUR/USD pushing back towards recent lows in the 1.1200 area.

A Reuters poll released on Wednesday suggested that market participants agree that Eurozone inflation will drop back under 2.0% by the year’s end and do not view the ECB as likely to begin hiking interest rates before 2023. That suggests markets continue to buy heavily into the story that while the exit from extraordinary ECB stimulus is on the horizon, the central bank’s monetary tightening plans are set to lag the Fed by a large margin. Indeed, consensus Fed calls are for as many as eight rate hikes by the end of 2023. It is thus not surprising to see that the US/German 2-year spread continues to surge and is on Wednesday trading at its highest since March 2020 at near 165bps. With some analysts calling for the US 2-year yield to hit 1.5% in the coming months (currently at 1.05%), further widening of US/Eurozone 2-year spreads is another reason to favour a lower EUR/USD.