EUR/USD recovery looks fragile amid war risks as US dollar eyes FOMC

The Euro is climbing for the third day against the US dollar as prices moderate after the war in Ukraine sank the European currency. The move higher comes as European leaders meet with Ukrainian President Volodymyr Zelensky in Kyiv. Although fighting near the city is intensifying, EUR/USD has risen almost 1.5% from its lows last week, suggesting traders see geopolitical risks potentially waning. That view is highly speculative and likely premature, however.

EUR/USD remains sharply lower, and the chance for a recovery to pre-war levels looks slim outside of a major de-escalation in Eastern Europe. Meanwhile, the resolve among Western powers only appears to be strengthening, demonstrated by the current delegation in Kyiv. That group includes Poland’s Prime Minister Mateusz Morawiecki, who stated that 'Europe must guarantee Ukraine’s independence.' Ukrainian President Zelensky continues to call on NATO leaders to implement a no-fly zone, although the alliance doesn’t appear ready for that.The United States has cited the possibility that Moscow would view it as a major escalation.

Tonight’s Federal Open Market Committee (FOMC) interest rate decision may inject some considerable price swings into EUR/USD. The broad-based US dollar DXY index remains near its 2022 high set earlier this month. That move was driven primarily by Euro weakness. However, it is rather difficult to gauge how DXY will react to tonight’s FOMC, given we are already at relatively elevated levels.

The Treasury yield curve between the ten-year and two-year rates is also within 30 basis points of inverting, a commonly-watched recession indicator. The Fed is in a rather tight position here. That said, the summary of updated economic projections and Fed Chair Jerome Powell’s commentary are likely to drive the USD more so than the actual policy decision itself.

The spillover effects from Western sanctions on Russia have also placed enormous stress on the banking sector, evidenced by the FRA-OIS spread’s elevated level. That spread – a common proxy to gauge interbank funding stress – measures the difference between the US three-month forward and the overnight index swap rate. The EUR/USD’s modest rebound corresponds with a small pullback in that spread. However, funding conditions remain strained compared to pre-war levels (See chart below). That benefits the US dollar’s haven status.

Follow Thomas Westwater on Twitter @FxWestwater

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