ING’s Francesco Pesole highlights that EUR/USD has been pressured by an equity sell-off and weak German PMIs, reinforcing a US-EU growth divergence narrative. He notes a wider EUR:USD two-year swap differential and a renewed Dollar risk premium. Despite near-term downside risks toward 1.1300, Pesole sees the pair as undervalued and remains optimistic about a recovery in coming months.

Short-term downside, medium-term recovery

"The equity sell-off primarily drove yesterday’s EUR/USD drop, but PMIs also did little to challenge the narrative of diverging US-EU growth. While US surveys got a small bump from the Middle East de-escalation, Germany’s service PMIs dropped from 48.1 to 46.8, dragging the composite further into contraction territory. That clouded an otherwise decent read for the eurozone, where the composite PMI at 49.5 is close to returning to expansion."

"On the positive side for the euro, ECB Chief Economist Philip Lane sounded quite hawkish, warning that inflation is set to stay above 2% for some time. This looks like an attempt to push back against President Lagarde’s dovish messaging on Monday, with Lane perhaps better reflecting current Governing Council consensus. There’s a good chance we’ll hear more ECB members offering a more hawkish stance for that reason."

"Still, the EUR:USD two-year swap rate differential is now at the widest since September. Back then, markets were maintaining a material risk premium on the dollar on the back of the long tail of Liberation Day and USD hedging flows. The spring energy crisis is making markets more prone to price that risk premium into the euro instead."

"EUR/USD is at risk of testing 1.1300 sooner than later, but we are already trading at almost 1% undervaluation relative to our short-term fair value estimate, and we remain generally optimistic on a recovery in the coming months as Fed hawkish bets may start to be gradually scaled back."

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