EUR/USD finished the week near 1.1650 after a sharp fall in oil prices. US rates retreated, with the 10-year Treasury yield at 4.43%, more than 20bp below its mid-May peak; however, the effect on EUR/USD FX swaps was muted because euro area rates also declined.
Euro area May flash inflation from Germany, France, Italy and Spain—about 75% of the aggregate—pointed to a headline pickup driven largely by energy. France, Italy and Spain were broadly in line with expectations, while German regional CPI surprised to the downside. Data due include April unemployment, expected at 6.2% in line with consensus, and the final May manufacturing PMI, expected to confirm the flash reading of 51.4. Attention then shifts to euro area flash HICP on Tuesday, while US labour market releases run through the week ahead of Friday’s jobs report.
Interest Rate Outlook And EUR/USD Range
With EUR/USD currently trading around 1.0850, the main driver is the shifting outlook on interest rates. US 10-year Treasury yields have recently eased back towards 4.50%, but this has been matched by similar moves in European government bonds. This has kept the pair in a relatively tight range for now.
We see that the latest flash inflation data for the Eurozone in May came in slightly hotter than expected at 2.6%, up from 2.4% in April. Despite this, the figures are not alarming enough to change the prevailing view of the European Central Bank’s path. Markets are pricing in a greater than 90% chance of an ECB rate cut at its meeting this week, the first since 2019.
Policy Divergence, Volatility, And ECB Easing Prospects
The focus this week will be on the policy divergence between the ECB and the US Federal Reserve. All eyes are on the US jobs report this Friday, with consensus expecting a solid, but not spectacular, addition of around 180,000 jobs for May. A number like this would reinforce the idea that the Fed has no reason to rush into cutting rates, unlike its European counterpart.
Given this backdrop, we believe implied volatility in EUR/USD is too low for the events ahead. One-month volatility is hovering near 5.5%, a level that seems to underestimate the potential for a move following the central bank decisions. We think traders should consider buying short-dated put options to position for a potential break lower in the pair.
The recent drop in WTI crude oil prices to below $80 a barrel further supports the case for a more dovish ECB. Lower energy costs will help tame future inflation prints in the energy-dependent Eurozone. This gives the central bank even more justification to begin its easing cycle, which should weigh on the euro in the medium term.
