EUR/USD Forecast 2023: Can the ECB Return the EUR to $1.15?

It was an eventful 2022 for the EUR/USD and for the markets to look back on. Market conditions turned bearish rapidly in response to surging inflation stemming from the war in Ukraine, supply chain disruption, and surging demand as economies eased COVID-19 restrictions.

Surging energy prices drove inflation to unprecedented levels, forcing central banks to act. The Federal Reserve led the charge, leading the EUR/USD to below parity for the first time since 2002.

However, a hawkish ECB and market bets of a Fed pivot supported a EUR recovery from a 2022 low of $0.95358 to end the year at $1.06994, marking a loss of 6.1%.

Despite the EUR/USD move through parity, the pair face many uncertainties going into 2023. While the high degree of uncertainty leaves the outlook for 2023 mixed, certain factors will likely dictate the direction of the EUR/USD throughout the year.

US Inflation and Fed Monetary Policy

Recent inflation figures suggest that inflation has peaked and that the Fed can take its foot off the gas. The shift in sentiment delivered dollar weakness, allowing the EUR to limit its losses for the year.

While the last FOMC projections were hawkish, CPI reports in early 2023 could decide the fate of the EUR/USD through H1 2023. An unexpected pickup in inflation would force the Fed to stick to its projected interest rate trajectory and push rates higher for longer.

High rates could force a deeper global economic recession and a hard landing that would drive demand for the dollar.

In contrast, softer inflation numbers would allow the Fed to take its foot off the gas and deliver a soft landing. Dollar weakness would prevail though any downside would likely be affected by the global macroeconomic environment.

The other question will be when the Fed reverses policy to support an economic recovery. Likely through H2 2023, the focus will shift to the Fed and the ECB loosening monetary policy to avoid prolonged recessions and elevated unemployment levels.

Again, this could be an area for dollar weakness, with the Fed likely to pivot ahead of the ECB. Once more, however, the macroeconomic environment would dictate the actual impact on the EUR/USD. A deep euro area recession would leave the dollar in the driving seat and the EUR/USD under pressure throughout H2 2023.

While inflation will be the focal point, market participants should also consider US labor market conditions. Resilient labor market conditions would force the Fed to lift rates higher to bring unemployment towards the 5% target. Currently, the US unemployment rate sits at 3.7%, giving the Fed plenty of wriggle room to tackle another inflation spike.

Hawkish ECB that Pursues Inflation Goal

In the final months of 2022, the ECB took a more hawkish stance to bring inflation to target, contributing to the EUR/USD rise from below parity.

If ECB President Lagarde’s guidance is anything to go by, the ECB is unlikely to take its foot off the gas anytime soon. A more hawkish ECB would shift monetary policy divergence in favor of the EUR.

However, the jury is out on whether the euro area economy can stomach ECB plans to bring inflation to target. An ECB-induced economic recession could have the reverse impact on the EUR/USD, with a hawkish ECB likely to send the EUR/USD back toward parity.

Considering the lasting effects of the Fed’s interest rate hikes and the impact of policy moves by other central banks to bring inflation to target, a global economic recession would also weigh on the EUR/USD. The euro area is more dependent on global demand and, therefore, sensitive to the global macroeconomic environment.

EUR Curve Balls

• War in Ukraine – prolonged energy crisis (EUR negative).
• COVID-19 China/Global Response to surge in new cases (dollar positive).
• Russia-China alliance – Taiwan, geo-political instability (dollar positive).
• Euro Area Instability – social unrest stemming from economic recession and higher youth unemployment leading to a more meaningful shift away from mainstream politics. Question mark over the EUR.

EUR/USD Best, Worst, and Base Case Scenarios for 2023

Several outcomes are possible when considering the factors that could impact the EUR/USD in 2023.

Base Case:

• Inflation softens further in January and February.
• Euro area and the US experience mild recessions.
• Softer inflation allows the ECB and the Fed to take their foot off the gas in Q1.
• War in Ukraine continues, but Russia shows no sign of escalating its offensive.
• China holds back from forging stronger ties with Russia, and Taiwan remains a hotly debated topic.
• COVID-19 surge fizzles out, removing the fear of new strains and fresh restrictions to prevent a global spread of the virus.

EUR/USD returns to $1.10, with a possible move to $1.13 on improving economic conditions in H2 2023.

Best Case:

• Inflationary pressures crumble on weak demand through January.
• Fed and the ECB hit ‘pause’ on interest rate hikes to limit economic fallout. Possible talk of interest rate cuts in H2 2023.
• The war in Ukraine ends, and Russia removes all supply restrictions to end the energy crisis.
• Euro area returns to growth in H2 2023.
• New COVID-19 strains are less virulent and less of a health hazard than the flu.
• China remains on the sidelines vis-à-vis Russia and focuses on rebuilding its economy rather than on Taiwan.
• The political environment stabilizes across the euro area, supported by improved employment conditions and lower inflation.

EUR/USD moves through the 2022 high of $1.14948 to target the $1.17 handle.

Worst Case:

• Inflationary pressures reignite, forcing the ECB and the Fed to push ahead on aggressive interest rate trajectories.
• Economies fall into deep recessions, leading to a marked increase in unemployment rates.
• The war in Ukraine intensifies, with China and Russia forging a political alliance.
• COVID-19 strains are more virulent than the Delta strain, forcing governments to shut borders to control the spread of the virus.
• Euro area political environment destabilizes, fueled by a jump in youth unemployment and social unrest, driving support away from mainstream political parties.

EUR/USD slides through the 2022 low of $0.95358 to bring sub-$0.90 into view for the first time since 2002.