2 fundamental reasons to buy the EUR/USD in 2023

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on Dec 22, 2022
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  • The ECB's balance sheet shrinks at a fast pace due to TLTROs repayments
  • Quantitative tightening in 2023 to take over
  • ECB was more hawkish than the Fed at the last meeting

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EUR/USD is the most liquid currency pair on the FX market. Also, it is the most popular one among retail traders.

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A currency pair reflects the difference between the two monetary policies of the central banks it represents. In this case, the European Central Bank (ECB) and the Federal Reserve of the United States (Fed).

Central banks set the interest rate level based on various economic factors. They constantly interpret economic data to determine the right interest rates in line with their mandate.

But lately (i.e., in the last decade), monetary policy has gone beyond interpreting only the economic data. Unconventional measures, such as quantitative easing and quantitative tightening, have changed the monetary policy spectrum.

As such, to a large extent, the FX market moves more on decisions regarding the expansion or contraction of central banks’ balance sheets than on the actual interest rate decisions.

Therefore, the two are pillars of the FX market’s volatility. And they both favor a higher EUR against the USD in 2023. `

Euro area excess liquidity is dropping fast

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One of the bullish things about the euro in 2023 is the fact that excess liquidity in the European financial system is dropping fast. It dropped below EUR4 trillion after a new round of TLTROs (Targeted Long-Term Refinancing Operations) settled yesterday.

TLTROs are another unconventional measure used by the ECB during the recent crises. But since the ECB changed the terms retroactively in the last quarter of this year, the TLTROs are not attractive anymore to commercial banks, so they are repaying the loans.

The repayment will drive the ECB balance sheet lower until June 2023, and then the quantitative tightening will take it from there. Therefore, the less liquidity in the system, the more the euro will be supported on dips.  

ECB more hawkish than the Fed

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Another consideration is the interest rate differential between the Fed and the ECB. The Fed recently signaled the slowdown of its interest rate hikes, and the ECB lowered it too.

But the ECB turned out to be more hawkish than the Fed. It signaled determination to move the rates much higher, and it has more room to catch up with the Fed.

Summing up, the euro looks bullish against the dollar. The risks to this forecast come from developments in the war in Ukraine and on the energy markets, as the US is a net exporter of LNG and other energy products to Europe.

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