Why a tug of war is shaping up in the euro-dollar

Euro and United States bank notes
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Opposing forces are set to keep the euro-dollar locked in a tense tug of war, analysts told CNBC.

"A tug of war is shaping up in the euro-dollar with jawboning by European policymakers putting downside pressure on the pair and the recent decline in U.S. yields providing upside support," said Kathy Lien, managing director at BK Asset Management.

According to Lien, both forces are significant enough to keep the euro-dollar locked in a $1.36 to $1.40 trading range for the foreseeable future.

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European Central Bank (ECB) President Mario Draghi said at a conference on Sunday that "a further strengthening of the exchange rate would require further stimulus." His comment - the strongest signal yet that the bank was poised to ease - saw the euro-dollar fall from recent highs.

In mid-March the euro-dollar strengthened to $1.3967 - its highest level since late 2011 - worrying ECB policy makers as a strong currency can lead to lower inflation. By mid-morning in Asia on Tuesday, the euro-dollar was trading at $1.3817.

"European policymakers do not want to see the euro-dollar trade above $1.40 and if it gets there, the chance of ECB easing will skyrocket," said Lien.

However, the ECB's desire to weaken the euro-dollar will face a headwind in the form of a weakening greenback, Lien pointed out, which could keep the euro elevated.

Downside pressure on U.S. Treasury yields would keep the dollar low, she said, as lower yields reduce the incentive for investment, thereby weakening the currency.

Following the Monday's U.S. retail sales data, yields on the 10-year Treasury edged up three basis points, before pulling back to finish U.S. trading 1.6 basis points higher, a move Lien described as "anemic."

"While the positive report lifted U.S. stocks, the greenback won't be able to rise without an increase in yields," she said.

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She added that for the euro-dollar to break out of the 1.36 to 1.40 trading range the ECB needs to ease or U.S. yields need to recover, sending the euro-dollar sharply lower.

"But if 10 year Treasury yields drop below 2.5 percent, the central bank may not be able to prevent euro-dollar from rising above 1.40," she added.

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Other analysts pointed out that the ECB might not necessarily be able to tame euro strength completely even if it does ease its monetary policy, given that positive sentiment on the euro zone has triggered a return of capital flows to the region, a trend that seems to be gaining traction.

"If the ECB does ultimately engage QE (quantitative easing) then that should be negative for the euro. But there is a lot of water to flow under the bridge before we see that," said David Forrester, G-10 foreign exchange and fixed income strategist at Macquarie Bank.

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"Essentially they can do another rate cut but the source of disinflation in Europe is not just a strong euro it's also a lack of credit growth and the ECB's asset quality review and bank stress tests due out in October will also be relied upon to beat disinflation," he added.

Patrick Bennett, FX Strategist at CIBC, told CNBC he also saw the euro-dollar remaining range bound around the high $1.30s, but said the greater impetus for the trend would be continued greenback weakness, rather than what's happening in the euro zone.

"We need to wait to the end of tapering, that's when the market will be more confident about when rate rises will begin and I believe that the market is too ambitious with those expectations," he added.

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