EUR: Election jitters and ECB rate cut add to downside pressures

Key points:

• EURUSD down to over 1-month lows as a fallout from the EU parliament election outcome resulting in a snap election being called in France
• The ECB’s recent rate cut has also weakened euro’s yield advantage, likely limiting the upside.
• EURUSD might stabilize amid upcoming US inflation data and the Fed meeting, but medium-term risks for the euro remain high, with potential to drop towards 1.05.

The euro is experiencing significant downward pressure, with EURUSD sliding below the 1.0780 support level and hitting over 1-month lows due to a double blow:

1. Stronger US Dollar: A surprise upside in the Non-Farm Payrolls (NFP) report suggests a more robust US labor market than anticipated, potentially delaying Fed rate cut expectations.
2. EU Political Turmoil: Political instability in the EU is adding pressure on the euro. Leaders from Germany and France faced defeats in the EU parliament elections, with far-right parties gaining traction. French President Macron called for a snap election in France after a humiliating defeat, potentially leading to more political instability. This adds to deficit risk, highlighted by S&P’s recent downgrade of France’s sovereign credit rating.

The bearish sentiment is further fueled by last week's ECB rate cut, which, despite a neutral bias and non-committal approach to further easing. The central bank’s rate cut has lowered the yield advantage on the euro. The ECB’s dovish stance compared to the Fed, and potential for further cuts, exacerbates this.

Additional factors contributing to short-term bearishness include:

1. Slowing China Momentum: The recent gains in China are slowing, and the scope for fresh stimulus is increasingly difficult as Fed rate cuts are delayed.
2. CFTC Positioning: Net long positions on the euro have reached their highest levels since March.

EURUSD is currently trading around 1.0760 and could test 1.0720 as US markets come online. However, there could be room for recovery later in the week as liquidity improves and markets position for the US CPI and Fed meeting.

The resilient US economy might prompt the Fed to shift to a relatively hawkish stance, potentially guiding for two rate cuts this year instead of three in their Dot Plot. This would still be a dovish message compared to market expectations, which signal ~36bps of rate cuts for this year.

To summarize, the scenarios for EURUSD this week include:

1. Fed’s Dot Plot Showing 1 Rate Cut for 2024: EURUSD could move lower to 1.07.
2. Fed’s Dot Plot Showing 2 Rate Cuts for 2024: EURUSD could rebound to 1.0820+.
3. Fed’s Dot Plot Showing 3 Rate Cuts for 2024: EURUSD could climb back to 1.09.

In the medium term, risks for the euro have increased, opening the door to a potential move towards 1.05.