EUR/USD drops to a five-year low; is it safe to buy it here?

The pressure on the common currency continues as the euro is sold across the FX dashboard. The conflict in Eastern Europe, triggered by Russia’s invasion of Ukraine, weighs on the common currency.

In response to the aggression, European nations reacted with a package of sanctions designed to weaken the Russian economy. But most of these actions have an impact on the European economies too, already weakened by the COVID-19 pandemic.

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Yesterday, news broke that Russia is cutting its gas supplies to Poland and Bulgaria. Since then, the EUR/USD dropped below 1.06, to a new five-year low.

Considering that the Federal Reserve of the United States is set to deliver a new rate hike part of its tightening cycle next week, does it make sense to buy the EUR/USD here?

A reversal might be possible

Buying the EUR/USD here is risky. This is a bearish market and while some signs of a reversal do exist, traders would be better off waiting for the market to move first and act second.

One potential bullish reversal is a falling wedge pattern. During such a pattern, the market typically reaches the 1-3 trendline before reversing.

Today’s move is enough to respect this condition, but traders should wait for the price to move above the 2-4  trendline before buying the EUR/USD.

Another potential bullish signal is the possible divergence with the RSI. If the RSI climbs back above oversold territory (i.e., above 30) without making a new lower low, then a bullish divergence may give the green light for a long position.

Fundamentals favor a stronger dollar

In currency trading, it is all about what central banks decide on the monetary policy front. The divergence between the Fed and the ECB could not be wider – the ECB keeps the rates in negative territory while the Fed already hiked them from the lower boundary and wants to lift them even more aggressively.

As such, the only way the EUR/USD may bounce from here is if the Fed’s actions are already priced in. In other words, by the time the Fed lifts the rates again at its next meeting, the US dollar may decline because the market has already priced in all the future rate hikes to be delivered in 2022.