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Why EUR/USD is on Course for the 2018 Low

Exchange rate analysis

Image © kasto, Adobe Stock

- EUR/USD has broken below 1.1432 level

- This has opened the way to target at 1.1301

- Italian budgetary risks still weigh

The EUR/USD pair has fallen again after negative economic data and continued Italian budget concerns pressured the Euro lower midweek.

The pair has now broken below the key 1.1432 lows and is probably on a course down to a target at 1.1301 and the key August 15 (and 2018) lows.

"Technically, a break of the 9 October low at 1.1432 is also a significant one as it opens up room for sellers to roam towards the year's low @ 1.1301," says Justin Low, an analyst at Forexlive.

Investors are selling their Euros ahead of the European Central Bank (ECB) meeting on Thursday.

Recent poor data, including a sharp and unexpected fall in PMI survey data for October has led to speculation the president of the ECB, Mario Draghi, might adopt a marginally more dovish tone.

Dovish means cautious about the economic outlook and interest rates. This would likely push the Euro lower.

Whilst the exchange rate may stall around the 1.1400 level where there is a some technical support which could hold it up, however, Low advocates a more bearish view that the pair will fall all the way to the 1.1301 level.

"There is some support seen around the 1.1400 handle but the technical break suggests that we're looking towards a re-test of the year's lows unless the ECB and Draghi pulls a hawk out of the hat tomorrow," says Low.

Overall the ECB is expected to steer a midway course between dovish and hawkish. They are unlikely to say anything to "spook the markets," says Low, because the Euro is right "where they want it to be."

The relatively weak Euro is a benefit to exporters and this is an important source of strength for the region. A weak Euro is also a boost to inflation because it increases the price of foreign imports, and inflation is struggling to rally.

"Although core inflation has softened a little, it hasn't derailed the ECB's outlook all too much and Germany's continued economic woes is a point of concern but it's not yet time for the central bank to commit to a different rhetoric from what they have been preaching over the past six months," says the analyst.

 

Italian Deficit Fears Still Weigh

Another important driver for EUR/USD is the Italian debt crisis reflected in the close correlation between the German-to-Italian (Bund-to-BTP) bond yield spread - which is the difference between the interest rate charged on loans to the German and the Italian government - and EUR/USD.

Since the Italian budget crisis the yield spread has widened as fearful investors started to charge Italy higher interest rates, this coincided to a high degree with a decline in EUR/USD.

"As just one measure of how important Italian markets have become in driving EUR/USD this year, it’s worth noting there has been close to an 85% inverse correlation between the performance of the currency pair and the 10-year Bund/BTP spread over the past six months," says Lee Hardmann, FX Strategist at MUFG.

Italian budgetary concerns and the increasingly tense relationship between the Italian government and the ECB continue to pressure EUR/USD lower and are expected to get worse.

"Beyond the near-term relief, we still believe that risks remain tilted to the downside for the euro from ongoing budget developments in Italy," says Hardmann.

Analysts at Barclays are also bearish the Euro over the longer-term due to tensions between Rome and Brussels.

"As a base case, we expect the tensions between the EC and Italy to mount in coming weeks introducing a lot of headline volatility and choppy price action for the EUR/USD. Under the base case, however, we expect the pair to oscillate around our year-end forecast of 1.15," says Nikolaos Sgouropoulos, vice president of currency strategy at Barclays.

Standard & Poor's assessment of Italy's credit rating on Friday, October 26, is the next key event for Italy and a negative downgrade would risk pushing the Euro lower.

Beyond that, November 13 is the next main event as it will mark the deadline for Italy to re-present its budget to the EU - 3-weeks on from the failed attempt on October 23.

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