MUFG expects EUR/USD to recover toward 1.1800 as confidence improves

EUR/USD is currently trading the lower end of its year-long 1.1400-1.1800 range, having come under sustained selling pressure from the energy shock and fading ECB rate hike expectations. Improving business confidence readings and unexpectedly resilient industrial production data suggest the worst of the growth hit may be passing, which should reduce downside risk for the euro in the near term. A faster than expected unwind of the energy shock, combined with the prospect of one more ECB rate hike in September, points to scope for EUR/USD to recover back toward the top of its recent range rather than break lower.

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EUR/USD is testing the base of its 1.1400-1.1800 range, but MUFG expects a rebound toward the top of that range as euro area growth proves more resilient than feared and business confidence recovers from the energy shock.

Summary:

• EUR/USD is trading just above 1.1400, testing the bottom of its 1.1400-1.1800 range after failing to break lower on a sustained basis last month
• The euro has faced selling pressure from the energy price shock's hit to investor sentiment and scaled-back ECB rate hike expectations
• The composite business confidence reading rose back to 50.0 in June from a May low of 48.5, though still below its pre-conflict level near 52.0 in February
• Stronger than expected industrial production data from France and Spain, along with upward revisions to April figures, prompted an upgrade to euro area Q2 GDP growth forecasts to 0.25% from near-stagnation
• EUR/USD is expected to rebound toward the top of its 1.1400-1.1800 range as cyclical momentum improves
• A final 25 basis point ECB rate hike in September remains expected, with officials including Chief Economist Philip Lane continuing to signal it is possible

EUR/USD is trading just above the 1.1400 level at the start of this week, testing the bottom of the 1.1400-1.1800 range that has held for the past year, after a failed attempt to break lower on a sustained basis at the end of last month. According to MUFG, the euro has faced persistent selling pressure in recent months, driven initially by the hit to investor sentiment from the energy price shock and, more recently, by scaled-back expectations for further ECB rate hikes. Euro area economic data significantly undershot expectations in the first two to three months of the conflict.

There are signs, however, that the worst of that shock may be passing. The final composite business confidence reading climbed back to the 50.0 level in June from a low of 48.5 in May, though it remains below the near 52.0 level seen in February, before the US-Iran conflict began, leaving room for further improvement in the months ahead. Separately, data released at the end of last week showed the euro area economy holding up better than feared in the second quarter. Stronger than expected industrial production figures from France and Spain for May, together with meaningful upward revisions to April data, prompted an upgrade to second quarter GDP growth expectations to 0.25%, from a prior forecast of near stagnation.

That resilience is seen as a supportive factor for the euro, helping to cap further selling pressure, while a faster than anticipated unwind of the energy shock should lift investor sentiment toward both the euro area economy and the currency for the remainder of the year. Improving cyclical momentum is expected to encourage EUR/USD to rebound back toward the top of its 1.1400-1.1800 range. A final ECB rate hike in September is still assumed, even though upside inflation risks have eased considerably, with officials including Chief Economist Philip Lane continuing to signal that another 25 basis point move remains on the table.

While a September hike is far from certain, the combination of improving growth momentum and the possibility of one more rate increase gives the euro a more constructive backdrop than it has had for much of the conflict period, supporting the case for a recovery toward the upper end of its established trading range.