EUR/USD gains relief from easing geopolitical tensions

• EUR/USD finds support from a lack of escalation in the Israel-Iran conflict. 
• Diverging interest rate expectations are an overall bearish factor however. 
• EUR/USD may be forming a Bear Flag price pattern. 

EUR/USD continues to trade within a contained box-like range, up a marginal tenth of a percentage point in the 1.0660s on Monday. 

A lack of escalation in the Israel-Iran conflict has led to an unwinding in geopolitical risk, which has reduced demand for the safe-haven US Dollar and provided EUR/USD with a slight lift. 

Most analysts are bearish EUR/USD, however, because of a diverging outlook for future path of interest rates - a key FX driver - in the US as compared to Europe.

EUR/USD doomed by diverging interest rates

EUR/USD is expected to continue weakening by many experts because of the comparative outlook for interest rates, which drive capital flows. Interest rates are expected to remain higher in the US compared to Europe, making it a more attractive place to store capital, thereby increasing inflows and Dollar-demand. 

On the US side, stubbornly high inflation, a robust jobs market and strong economic growth are all reasons to keep interest rates at their current level (5.25%-5.50%).

"It is hard to find any reasons to bet against the Dollar," said Michael Pfister, FX Analyst at Commerzbank in an interview with Bloomberg News on Monday. "We have seen an appreciation in the Greenback over the last two weeks on the back of an inflation surprise. On top of that we have a strong growth advantage and a very hawkish Fed," added the analyst. 

Pfister sees the Federal Reserve (Fed) not making a first rate cut until December, which is a big change from expectations earlier this year, when the consensus was that the Fed would make its first interest rate cut in June. The Fed themselves, in their last Summary of Economic Projections (SEP), forecast about three 0.25% cuts over the whole of 2024. 

This contrasts with Europe, where disinflation has been stronger and economic activity weaker. Additionally, officials at the European Central Bank (ECB) which sets base lending rates for the entire region (currently at 4.5%), appear more united in advocating for a cut in June, compared to their colleagues across the Atlantic.  

"To be honest, I am often surprised that the Euro is not much weaker," says Ulrich Leuchtmann, Head of FX and Commodity Research also at Commerzbank in a note on Monday. 

"Over the weekend, news services reported in advance on an interview with François Villeroy de Galhau, Governor of the Banque de France. According to these reports, Villeroy confirmed the ECB Governing Council's intention to cut interest rates at its meeting on June 6," adds Leuchtmann. 

How low could the Euro go? When asked whether he saw EUR/USD falling all the way to parity, Pfister replied "Not quite as low as parity but we see EUR/USD probably falling to 1.0400." 

Technical Analysis: EUR/USD forms potential Bear Flag

EUR/USD has been yo-yoing in a rectangular range since it bottomed at 1.0601 on April 16. The range is roughly at the level of the 100-week Simple Moving Average (SMA). 

Taken together with the steep decline that preceded it, the rectangle resembles an almost-complete Bear Flag pattern on the 4-hour chart below. 

EUR/USD 4-hour Chart

A break below the 1.0601 April 16 low would signal a probable activation of the Bear Flag and the start of a deep decline. Technical analysts forecast the move out of a Bear Flag as equal to the length of the "pole" or the steep decline preceding the box-like formation of the flag square, or a Fibonacci ratio of the pole. 

The Fibonacci 0.618 ratio of the pole extrapolated lower provides the most reliable conservative target. This gives a price objective at 1.0503.  After that, the next concrete target is at 1.0446 - the October 2023 low. A fall of equal length to the pole would take the exchange rate all the way down to 1.0403. 

The Relative Strength Index (RSI) has exited oversold conditions, indicating renewed potential for more downside. 

For bulls, resistance at around 1.0700 will need to be overcome to have any hope of recovery. After that, the April 2 swing low at 1.0725 provides the next upside target followed by 1.0800, where a cluster of major Moving Averages coils.