Recovery May Continue but Upside Will Be Limited

EUR/USD FORECAST:

• The euro continued to strengthen against the U.S. dollar during the first three months of the year
• Heading into the second quarter, EUR/USD is likely to remain in an upward trajectory
• Download our full quarterly euro forecast for a more comprehensive view of the common currency’s outlook

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The euro gained ground against the U.S dollar during the first three months of 2023, extending its rebound that began in October of last year, though its advance did not follow a straight line and encountered several obstacles. This was a sign of only moderate bullish conviction in the common currency.

There were multiple positive drivers for the euro to list, but one of them was the sharp pullback in natural gas prices. Chart 1 shows how the EUR/USD’s recovery has coincided with the downward correction in natural gas prices.

After reaching record highs above €300/MWh in August 2022, European natural gas prices tumbled back to earth, sinking more than 85% from those stratospheric levels. This prevented an energy crisis from unfolding following Russia’s weaponization of fossil fuel exports. In this context, the region’s economy managed to stabilize and even surprise on the upside.

By way of context, euro zone’s economic activity was projected to grow at a paltry 0.2% this year, but consensus estimates now point to a GDP expansion of around 0.8%, with the reopening of the Chinese economy also contributing to an improved outlook.

Chart 1: EUR/USD versus European Natural Gas Futures Prices (TTF)

Source: TradingView, prepared by Diego Colman

ECB Wavers on Guidance Amid Banking Sector Turmoil

Economic resilience, in turn, has given the European Central Bank the opportunity to press ahead with its hiking cycle in the fight to curb inflation, which stood at 8.5% y-o-y in February. While the bulk of the tightening may be over, policymakers are still likely to deliver between two and three additional hikes over the coming months. Perhaps even four.

It is true that the ECB refrained from giving guidance at its last meeting, but this was due to the US/ European banking sector upheaval. Market turmoil has since eased after U.S. authorities moved swiftly to shore up the financial system and Swiss regulators helped brokered a deal to rescue Credit Suisse before an imminent failure.

Monetary Policy Divergence to Benefit the Euro

Given that the European Central Bank is expected to raise rates a few more times through the summer while the FOMC stays on hold, there is scope for the euro to strengthen further against the U.S. dollar. However, monetary policy divergence will only offer modest support; after all the ECB’s terminal rate is seen reaching 4.0% at most versus 5.10% for the Fed.

In any case, euro’s bullish scenario could be reinforced if sentiment improves materially, but that is a tall bar to climb in a synchronized global slowdown and with the war in Ukraine raging on unabated.

To summarize, EUR/USD has the potential to keep rising during the second quarter, but its upside will be limited considering the current macro and financial backdrop.

In addition, the appreciatory trend could be interrupted from time to time if new episodes of risk aversion flare up, as these will bolster demand for haven assets. In general, when market turbulence erupts and volatility spikes, high-beta currencies such as the euro tend to perform poorly against the greenback.

This article focuses on the fundamental outlook for the euro, but if you would like to learn more about technical forecast and price action analysis, download DailyFX’s complete quarterly guide by clicking the link below. It’s free!