EURUSD is facing a lot of uncertainty in both the short term and the medium term. Inflation has put an end to its uptrend, but underlying inflation remains strong in both the US and the Eurozone. Rising energy prices and ongoing geopolitical risks are not helping the situation. With central banks hiking rates and reducing market liquidity through balance sheet operations, financial conditions are tightening, which is taking a toll on both banks and governments. The increase in yields means that the cost of new debt is rising, and both the Eurozone and US governments have significantly more debt due to COVID-19.
As for the banks, older bonds are causing a loss of profit, while the shrinking liquidity is putting banks in a difficult position, forcing them to decide whether to sell bond assets at a loss or not. The markets witnessed the impact of this when a couple of midsize banks failed in the US and Credit Suisse faced similar issues. According to ING, the Eurozone could potentially face a liquidity problem in 2024. Bank of Italy’s outgoing chair, Visco, has pointed out that Europe lags behind the US in managing banking crises and has a very complicated mechanism for doing so. ECB Vice Chair Guindos has also mentioned that the financial stability outlook is fragile as the financial system adapts to higher interest rates.
Banks might deplete their liquidity buffers to redeem LTRO (Long-Term Refinancing Operations) drawings and turn to bond markets to replenish their coffers, potentially increasing bond yields for banks and, perhaps, governments as well. Germany and Italy’s banks could be among the most affected by the LTRO drawings, but Italy could be the weakest link. The Italy-Germany yield spread has been on the rise again since the end of summer, increasing by more than 0.40 for the 10-year spread in the last two months. This trend is having a negative impact on EURUSD, and if it continues, the ECB might be compelled to take action in the coming months.
Since the start of October, EURUSD has been attempting a comeback. FED members are signaling the possibility of the end of the hiking cycle. Short-term risk reversals are approaching the positive side, but long-term reversals are telling a different story and trending more toward the downside. Long-term option traders might have observed mounting risks for the Eurozone, including liquidity risk, geopolitical risk, energy risk, and recession risk, which could pose more problems for the Eurozone in comparison to the US. In the short term, a possible shutdown in the US could be on the horizon which is favoring Euro a little bit more.
EURUSD has been trending sharply downward since July. In the last two weeks, the trend has faced aggressive testing, but there is no sign of a breakout yet. The RSI (Relative Strength Index) has also approached the 50 barrier. The 50 resistance of RSI has signaled a reversal to the downside in the last three attempts. As long as the downtrend continues, the bears could maintain control over EURUSD. A major support level to watch is at 1.048, which has been a key support over the medium to long term. If this support level breaks, EURUSD may target the midpoint of the 2022-2023 rise at 1.04, followed by the lower boundary of the trend channel.
EURUSD bulls should exercise patience at the moment. An end to the downtrend could be signaled by a close above 1.0615 with RSI closing above 50 or by approaching the lower boundary of the trend channel, creating potential buying opportunities with appropriate stop-loss levels. Additionally, moving significantly away from the 100-day moving average could serve as a favorable indicator for the bulls. If it falls to below 2.5 or 3 standard deviations, it might indicate a potential bullish turn, at least in the short term.
