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Until recently, the Eurozone economy had been demonstrating solid growth, supporting forecasts for further increases in GDP and inflation. It was expected that the ECB would be able to raise interest rates four more times before the end of the year, which would have supported the euro.
However, the latest May business activity data came in significantly weaker than expected. Although the manufacturing sector remained in expansion territory, growth slowed from 52.2 to 51.4 points. The services sector showed an even more pessimistic trend, falling into contraction territory at 46.4 points (compared to 47.6 in April). The composite index also declined to 47.5 points.
The ECB is currently maintaining a wait-and-see approach, preserving flexibility in its decision-making. However, incoming data paint a mixed picture. Daily closures of the Strait of Hormuz continue to support elevated oil prices, increasing inflationary pressure. This, in turn, raises the likelihood of a rate hike at the ECB's upcoming June meeting.
Such an economic slowdown could significantly alter expectations regarding ECB policy, since aggressive rate hikes risk triggering a recession in the Eurozone, especially given that there is little reason to expect a meaningful slowdown in inflation in the near future. Even a hypothetical agreement to end the blockade in the Persian Gulf would only partially offset the damage already done. Energy prices are likely to remain high until countries replenish their reserves.
At the same time, expectations for Federal Reserve policy are rapidly shifting toward a more hawkish stance. The market no longer expects rate cuts; instead, one rate hike is now projected before the end of the year, followed by another in March next year. The formal reason for the revision in forecasts was stronger-than-expected U.S. inflation data and resilient producer price index figures. As a result, the balance of risks has suddenly shifted toward a scenario in which U.S. inflation continues to accelerate without an adequate response from the Federal Reserve.
According to the latest CFTC report, speculative positioning in the euro is close to neutral, while the estimated fair value continues to decline steadily.
Last week, we noted the increasing likelihood of a downward move in EUR/USD, and this forecast remains unchanged despite the modest rebound following reports about a possible agreement between the United States and Iran. The euro may move somewhat higher in the short term if positive geopolitical news emerges, but upside potential appears limited to the 1.1700 level. We still consider a renewed decline more likely, initially toward the recent low at 1.1575, after which the pair could potentially move toward 1.1410.
*The market analysis posted here is meant to increase your awareness, but not to give instructions to make a trade.
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