MUFG strategists say EUR/USD has retreated toward the middle of its 1.1400–1.2000 range as the Euro faces headwinds from the Middle East energy shock and weaker euro-zone PMIs. They expect the ECB to delay tightening until June, delivering 50 bps in total, which creates near-term policy divergence with the Fed but still offers some support via narrowing yield spreads.

Energy shock weighs on Euro outlook

"The EUR has lost upward momentum over the past week, with both EUR/USD and EUR/GBP falling below 1.1700 and 0.8700, respectively. The pullback in EUR/USD follows a strong rally that fully reversed the initial losses seen at the start of the Middle East conflict, with the pair peaking at 1.1849 on 17th April. As a result, EUR/USD has slipped back toward the middle of the 1.1400–1.2000 trading range that has been in place since June last year."

"The recent correction in the EUR appears to have been driven by a combination of factors, including disappointment over the lack of progress in US–Iran talks aimed at reopening the Strait of Hormuz and emerging evidence of the initial negative impact of the energy price shock on the euro‑zone economy. The longer the Strait of Hormuz remains closed, the more disruptive the energy price shock is likely to be for the euro‑zone economy, reinforcing headwinds for the EUR."

"The ECB has clearly outlined three main scenarios for the euro‑zone economy in response to the energy price shock: baseline, adverse, and severe. In a recent speech, President Lagarde stated that she currently judges the euro‑zone economy to be positioned between the baseline and adverse scenarios. She noted that energy prices have not yet risen “far enough to push us squarely into our adverse scenario”, while European natural gas prices remain “below our baseline”."

"We continue to expect the ECB to deliver a cumulative 50bp of rate hikes, although the timing of the first increase is likely to be delayed until June. This creates scope for near‑term policy divergence between the ECB and the Fed, as the Fed appears more comfortable looking through the energy price shock on this occasion. Narrowing yield spreads have helped support the EUR and have softened USD strength in response to the energy price shock."

(This article was created with the help of an Artificial Intelligence tool and reviewed by an editor.)