The EUR/USD pair, the world’s most active traded currency pair, continued to see a recent weakening trend. During the Asian session on Friday, it slumped a bit, hinting a weak negative bias. This announcement follows a hard-fought effort to capitalize on yesterday’s positive momentum from the DOT. That high came on the heels of a three-week low around the 1.0730 zone. The duo is bedeviled by sometimes contradictory economic barometers. Market participants are now intently focused on next week’s data, particularly the US PCE Price Index and what it might have to say about the index’s trajectory going forward.
The Eurozone’s economic landscape and the policies of the European Central Bank (ECB) play critical roles in shaping the EUR/USD pair’s performance. Shutterstock The European Central Bank, headquartered in Frankfurt, Germany. It determines the Eurozone’s monetary policy, aiming mainly at price stability through inflation control and/or economic growth stimulation. Particularly with inflation dynamics and interest rate expectations in full focus, the Euro rides a treacherous but hopeful landscape.
The Significance of Currency Pair Trading
The EUR/USD currency pair that connects Europe and the United States is an important one, making up nearly 30% of global transactions. Its prominence overshadows all other major currency pairs. EUR/JPY, EUR/GBP and EUR/AUD currency pairs only make up 4%, 3% and 2% of transactions, respectively. This currency pair is in a different league. The Euro is the second most traded currency in the world, after the US Dollar. Beyond that, it has an essential role in international trade and finance.
The Euro is the common currency for 19 European Union countries that make up the Eurozone. For the EUR/USD pair, the economic health of the Eurozone is paramount to the pair’s valuation. Today economic data from Germany, France, Italy, and Spain are of high economic importance. These four largest economies alone are responsible for an estimated 75% of total economic output for the Eurozone.
Market participants closely monitor developments in these economies to gauge potential impacts on the Euro’s strength relative to the US Dollar. GDP growth, unemployment rates and consumer confidence greatly impact market sentiment. All of these factors directly impact currency exchange rates.
The Role of the European Central Bank
Only by delving into the ECB’s policy climate and key decisions, one can make sense of the euro/dollar pair’s wild swings. The ECB Governing Council, comprising heads of Eurozone national banks and six permanent members including President Christine Lagarde, convenes eight times annually to make key monetary policy decisions. These decisions include determining interest rates and directing the use of other monetary policy tools.
Perhaps the most important pillar of the ECB’s mission is to maintain price stability throughout the Eurozone. This goal usually aims for an inflation rate that is 2% target—not of 2% exactly, but rather just under 2%. For its measurement, a Harmonized Index of Consumer Prices (HICP) is used. The 2% target serves as a fundamental point of reference for assessing inflationary pressures across the Eurozone.
When inflation exceeds expectations, particularly if it surpasses the ECB’s target, the central bank may respond by raising interest rates to bring inflation back under control. The ECB acts when inflation remains too low for too long. Together, they put in place a combination of fiscal efforts to spur economic development with very expansionary monetary policy.
Implications of Inflation and Interest Rates
For one, inflation dynamics have a strong second order effect influence over EUR/USD pair price movements. Rising inflation tends to trigger speculation about upcoming interest rate increases by the ECB. This is because higher interest rates, or an expectation of future increases, usually favors a currency as it draws in foreign investment searching for a better return.
Persistent weak inflation might breed expectations of prolonged dovish monetary policy, putting downward pressure on a currency’s value. Market participants pay a lot of attention to how inflation is trending over in the Eurozone. They look for guidance on when and how much interest rates will be changed by the ECB.
As EUR/USD is a critically-relevant currency pair for many, unexpected changes to inflation data may send EUR/USD into abnormally higher volatility. Currency traders and investors absorb these trends and compare them with other economic indicators to make calculated bets on which currencies to buy/sell and futures positions to take.