EUR/USD has turned positive after falling to the October 14 daily low. Traders holding long positions may still be disappointed, though. Until broader market perceptions of the Fed and ECB move toward a more favorable setting, the pair's upside looks limited.

The rally off the October 14 low stalled near the downward-sloping 21-day moving average and resistance in the 1.1265/85 zone. It had been helped by a narrowing of the US-German 2-year yield spread , which the pair is correlated with. From October 2 to October 19, that spread tightened from roughly -181 bps to -164 bps. It then stalled at a key resistance zone. Since late last week, the spread has been widening again, which is weighing on EUR/USD.

Fed and ECB policy expectations help drive those spread moves. Investors currently expect the Fed to stay hawkish. They think the ECB may lean dovish, partly because of sell-offs in French, Italian and Spanish government bonds. The Fed is focused on fighting inflation, and the ECB faces downside economic risks amid uncertainty. Those perceptions are therefore unlikely to change soon, which should cap any significant EUR/USD rally and keep risks tilted to the downside.

The main threat to this bearish view would be a change in sentiment. If markets begin to price in a less hawkish Fed and a potentially hawkish ECB, EUR/USD could rally sharply and put the current downtrend in jeopardy.
DEUS


eurusd

(Christopher Romano is a Reuters market analyst. The views expressed are his own)