EUR/USD had one of the strongest performances on the FX dashboard in April and May. What will the rest of the year bring?
The EUR/USD pair is often viewed as one of the most important currency pairs on the FX dashboard. This is because it makes up about half of the Dollar index, so the EUR/USD is viewed as a benchmark for the dollar’s strength or weakness.
In the first quarter of the year, the EUR/USD dropped several big figures (i.e., several hundred pips). It has traded as high as 1.23 and beyond in January, only to fall to 1.17 toward the end of March.
But then it all changed. The ECB’s reluctance to expand the PEPP program, the failure to communicate its intentions to the market and the Fed’s willingness to keep an accommodating stance, all created a bullish environment for the EUR/USD. Since the start of April, the pair has risen from 1.17 to 1.22.
Yet, there is another interesting correlation to watch out for in the month ahead. Despite what the Fed and the ECB might or might not do, the pair closely followed the core inflation difference, or the advanced five-month inflation vs. the US core CPI.
EUR/USD Weakness During H2 2021?
April inflation data in the US has increased pressure on the Fed. Rising inflation suggests that during the summer, the US economy is at the risk of overheating. It means that the Fed might need to change its dovish signal into one more neutral, or maybe even a bit hawkish.
All Fed members, and some other central bankers around the world, have suggested that the recent spike in inflation is only transitory. More precisely, they see it fade away later in the year or at the start of the next year.
As the chart above shows, if that is the case, the EUR/USD follows the differential between the expectations and core inflation quite religiously. In the past five years, it did not miss a swing.
Therefore, if we are to interpret the future EUR/USD move based solely on the chart above, one of two things might happen. Either the EUR/USD drops to 1.05, then jumps to 1.30, followed by a move below 0.9, or it simply drops below parity. In both cases, the correlation suggests a move lower in the months ahead, despite the pair’s strength in the last couple of months.