EUR/USD Short Squeeze Underway as Yields Drag US Dollar Lower

EUR/USD is gaining momentum as falling Treasury yields undermine the US dollar, despite stronger GDP growth and stubborn inflation. With record bearish positioning in euro futures and the Fed reluctant to signal further tightening, the short squeeze could have further to run.

Euro Rebounds as Falling Treasury Yields Weigh on the US Dollar

US GDP Accelerates, but Consumer Spending Loses Momentum

The US dollar weakened despite GDP growth accelerating to 3.4% annualised in Q3 and core PCE inflation reaching 3.1% y/y. However, quarterly core inflation eased to 2.5% annualised from 3.3%, while real consumer spending stalled in September despite growing 3.8% annualised over Q3. Real disposable income also fell 0.3% m/m, suggesting households entered Q4 with less spending power.

Treasury yields fell across the curve as bond-market volatility continued to subside. With inflation broadly matching forecasts and the Fed unwilling to commit to further tightening, the data failed to generate a fresh hawkish repricing. Meanwhile, weakness in technology shares may have encouraged demand for Treasuries, adding downward pressure to yields.

ECB Holds Rates, but December Hike Remains in Play

The ECB held its deposit rate at 2.5% as expected, although the meeting carried a hawkish undertone as rising energy prices increased inflation risks. President Lagarde confirmed policymakers had discussed hiking immediately, but opted to wait for further data amid tighter financing conditions and concerns about economic growth.

A 25bp ECB hike in December now looks increasingly likely, although rising bond yields could limit how far policymakers can tighten thereafter. Market pricing suggests the ECB could tighten slightly faster than the Fed over the near term, although both central banks are expected to deliver around 60bp of cumulative hikes over six months. This leaves EUR/USD sensitive to relative bond yields and positioning, particularly given the sentiment extremes that could leave the euro vulnerable to a short squeeze.

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Falling Treasury yields and bond volatility weigh on the US dollar

Despite stronger US growth and elevated inflation, Treasury yields have fallen sharply from their October highs across the curve. Shorter-dated yields have experienced the largest percentage increases this year, with the two-year up nearly 30%, compared with around 14% for the 10-year and 7% for the 30-year. This has contributed to a substantial flattening of the yield curve, with the 10-year versus two-year spread narrowing to around 33bp from over 100bp earlier this year.

Meanwhile, the MOVE index has fallen towards 95, below its three- and six-month averages, pointing to declining Treasury-market volatility. The combination of falling yields and subdued volatility suggests markets are becoming less concerned about further aggressive tightening, despite stubborn inflation. Demand for Treasuries amid weakness in technology shares may also be contributing to the decline in yields.

The dollar's failure to rally on stronger economic data is therefore telling. For now, falling Treasury yields and a reassessment of the Fed's longer-term policy path appear to be outweighing the hawkish economic headlines. That could bode well for the euro, particularly given the sentiment extremes I previously warned could leave it vulnerable to a short squeeze.

US Dollar Index (DXY) Technical Outlook

The weekly charts shows how the dollar rally has stalled around the upper trend channel – after an inverted hammer candle met resistance around a long-term 50% level. At current prices, the USD index is on track for a shooting star week – which could also be a lower high. And with prices also beneath the May high, perhaps bears could gain some momentum if incoming US data even slightly lowballs.

The daily chart shows the lower more prominently, and bearish momentum is picking up pace. Perhaps a move down to 101 is on the cards, a break beneath which brings the 50-day SMA into focus.

Source: ICE, TradingView

EUR/USD Technical Outlook: Euro vs US Dollar

I sent a couple of reminder heading into the ECB meeting that euro futures were flashing a sentiment extreme.

The most recent Commitment of Traders (COT) report showed that large specs and asset managers had pushed net and gross-short exposure to a record high. Yet the inability for bears to drive EUR/USD beneath the May low to me suggested a crowded trade. And momentum has since turned higher. Given we’re now seeing the US dollar retreat on downwardly revised Fed expectations, the euro could have further to bounce in the coming weeks in my humble opinion.

Source: ICE, TradingView