Synopsis:

Credit Agricole predicts a continued downward pressure on EUR/USD due to diverging monetary policies between the European Central Bank (ECB) and the Federal Reserve. Despite potential inflationary pressures from a weak euro and high commodity prices, the bank sees limited impact from exchange rate movements on Eurozone inflation.

Key Points:

• Monetary Policy Divergence: The ongoing divergence in monetary policy between the ECB and the Fed is expected to be a key driver for EUR/USD. The Fed's outlook and the ECB's ability to match this stance will significantly influence the currency pair.

• ECB's Exchange Rate Concerns: ECB President Christine Lagarde has highlighted concerns that further weakening of the euro, coupled with high commodity prices, could increase inflationary pressures and potentially disrupt the ECB's plans for easing. However, Credit Agricole expresses skepticism about the market's reaction, suggesting that investors might test Lagarde's resolve on this issue.

• Exchange Rate Pass-through (ERPT) Effect: Recent data suggests that the pass-through effect of a weaker euro on Eurozone inflation has diminished compared to previous years. For instance, a 10% depreciation in the euro's nominal effective exchange rate (NEER) is now estimated to increase headline CPI by only 0.2-0.3% after four quarters, compared to 0.5% in earlier periods.

• Resilience of the Euro NEER: Despite the weakness observed in EUR/USD, the euro's nominal effective exchange rate has remained relatively stable, supporting the view that direct impacts on inflation might be subdued.

• Upcoming Inflation Data: The upcoming Eurozone April flash Harmonised Index of Consumer Prices (HICP) is expected to indicate further disinflation, reinforcing expectations for an ECB rate cut in June followed by additional easing measures later in the year.

• EUR/USD Outlook: Given these factors, Credit Agricole advises that EUR/USD should remain a sell on rallies next week, anticipating that any upward movements in the currency pair may be short-lived.

Conclusion: As the ECB and Fed continue on their divergent paths, EUR/USD is likely to face downward pressures, influenced by policy decisions and evolving economic indicators. Investors should closely monitor upcoming inflation data and ECB communications, as these will play crucial roles in shaping market expectations and the trajectory of EUR/USD. Selling on rallies could be a prudent strategy in this environment, given the limited efficacy of a weaker euro in driving up inflation and the anticipated monetary easing by the ECB.