EUR/USD forecast: Yield differentials are supporting the euro (for now)

EUR/USD seasonality

It has been a quiet start to the year for currency traders, with EUR/USD’s high-to-low range at just 1.6% in January so far. It is usually a bearish month according to its seasonality, with an average return of -1.2% using data since 1975, and it has closed lower 66.7% of the time. Over the past five years, EUR/USD has closed lower in January for four consecutive years until January 2023 posted a 1.5% gain. With two weeks to go, it is currently on track to close the month lower – but at just -0.7% on the month, there may be some more downside potential.

EUR/USD and the EU-US 2-year spread

However, a change in rate expectations has seen the EU-US 2-year spread shoot higher, which is likely helping to support EUR/USD. Bets that the Fed could cut rates five or more times this year has seen the 2-year yield fall below 4.2% for the first time since May 2023, although it clearly remains at a premium relative to Europe’s 2.5%. Still, I am of the belief that that market pricing is too optimistic regarding these cuts, and that leaves room for some disappointment and repricing in the weeks of months ahead, which could strengthen the US dollar and weigh on EUR/USD. As noted in my weekly COT report, traders were their most bearish to the US dollar in five months last week, and that leaves room for some short covering if the Fed hold rates and continue to push back on aggressive interest rate cuts.

EUR/USD technical analysis (daily chart):

If US yields continue to selloff, the EU-US 2-year spread could continue higher and take EUR/SUD with it. However, it has struggle to break above 1.10 this year since crashing through it on January 2^nd.

A bearish divergence has formed on the RSI (14) on the daily chart, and prices are now consolidating within a potential bear flag formation. Bears could seek to enter short a break of the cycle lows, or countertrend traders could seek to fade into moves towards 1.10 with a stop above the August high. 1.08 makes a viable target over the near-term.

-- Written by Matt Simpson

Follow Matt on Twitter @cLeverEdge

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