FEDvsECB Divergence Sparks Interest in EUR/USD

With the US economy seen growing while the EU staggers, the divergent outlook for rates between the Fed and ECB comes into focus.

The US Economy Is More than Resilient

According to the Fed's GDPNow estimate of economic performance so far this quarter, US Q3 GDP is expected to clock in at 4.1%, a substantial departure from the doom and gloom forecasts from earlier this year. It's barely the midpoint in the quarter, though, and Q2's figures are still not finalised yet, while the Fed's forecast more than triples the consensus among economists. But, at that rate, the Fed could be confident that their current rate hike policy is not only bringing inflation down but avoiding a hard landing.

That's not the only thing that the Fed and the consensus of economists differ on. The Fed's last dot-plot released in June shows one more rate hike from now to the end of the year. But less than a third of the market agrees with the Fed's assessment. So far this year, the market has been wrong about what the Fed ultimately does. Thus, the importance of the FOMC minutes is to see just how committed members are to taking that last rate hike. Now that inflation has come down, the focus is on the labour market as wages have finally started to rise faster than inflation. But at over 4.0%, that increase could be an obstacle to getting inflation back into the target range, especially as base effects kick in. In the latter half of last year, inflation slowed its rate of increase as the Fed pushed up rates. Now if FOMC members are worried about tightness in the labour markets, traders could start to think that another rate hike, potentially in November, might come about.

The ECB Between Inflation and Growth

The ECB isn't facing the base effects issue that the Fed is because it was slow to get into the hiking game, so inflation kept on rising through the second half of last year. That means the ECB can pare back its aggressive hiking while the annual measure of inflation keeps coming down. Taking a more measured approach to rates might help an economy that avoided a recession earlier this year by the bare minimum.

The eurozone will post its second look at Q2 economic growth, which is expected to confirm the quarterly lift-off in the economy, but the annual rate is still suffering. Q2 GDP is expected to be confirmed at 0.3%, up from 0.1% prior, while the annual pace is expected to be reiterated at 0.6%, down from 1.1% prior. Meanwhile, final July inflation is seen confirming the marginal decrease to 5.3% from 5.5% prior, with the core rate remaining unchanged at 5.5%. The sticky core rate has been a subject of intense debate in the ECB and is seen by analysts as potentially pushing the balance towards a rate hike in September. That might provide stability to the euro, as it would show the market is expecting the interest rate gap with the dollar to tighten next month.

EUR/USD in Wedge or Triangle

One can assume the upside in EUR/USD is done for now, pending pullbacks towards the major support at $1.05 due to a terminal wedge completion at $1.1278. However, while trading above the regional support at $1.0837, chances of seeing a triangle pan out to the projected measured move high of $1.1467 remain elevated. $1.1064 and $1.1155 are seen as interim resistances in such an event. On the flip side, losing the short-term floor will raise the probability of additional slides, with $1.0636 acting as potential levels of respite.

Source: SpreadEx / EURUSD

Key Takeaways

The recent FOMC minutes and EU GDP/CPI data have highlighted the contrasting economic outlooks between the US and the EU, impacting EURUSD. The US economy is showing strong growth, with Q3 GDP projected to be 4.1%. The Fed's dot-plot has led to another rate hike expectation this year, although the market consensus differs. The focus is now on the labour market and rising wages, which could impact inflation. In contrast, the ECB is taking a more cautious approach due to slower economic growth and declining inflation. Q2 GDP is expected to confirm a moderate expansion, but the annual rate remains weak. Inflation is also expected to decrease slightly. The sticky core inflation rate may push the ECB towards a rate hike in September, tightening the interest rate gap with the US dollar and providing stability to the euro.