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JP Morgan has downgraded its growth forecasts for China in a development that offers support to the Dollar while weighing on the Euro which is highly sensitive to growth prospects in the world's second-largest economy.

This development is expected to allow the US dollar (USD) to more freely respond to concerns related to the end of the economic cycle.

Meera Chandan, Global FX Strategist at JP Morgan, says the Euro to Dollar exchange rate (EUR/USD) pair is likely to test the 1.05 level as growth trades are pared down and the path of least resistance favours further upside in USD against the Chinese yuan (CNY).

Chandan stated, "Growth signals are not outright defensive yet, but recent changes pave the way for the dollar to more freely respond to elevated carry and end-of-cycle concerns."

The downgrading of China's growth outlook has solidified the notion that the robust growth momentum is now a thing of the past, prompting a shift towards defensive positions.

"China experiences first growth downgrade post-reopening; US growth has also been revised lower; how long can EMU remain resilient?" - JP Morgan.

Chandan recommends initiating USD long positions and scaling up defensive exposure, particularly through proxy shorts for the euro (EUR) and the yuan (CNY), including underweights in the British pound (GBP), Swedish krona (SEK), and New Zealand dollar (NZD) against a combination of USD and Swiss franc (CHF).

Chandan also highlighted the impact of growth and carry on the euro's long-run returns. The lack of carry has become less of an issue for the euro due to rate hikes by the European Central Bank (ECB). However, the recent outperformance of the euro reflects the exit of the currency from the funding basket, combined with improving growth.

Consequently, the downgrades in growth forecasts are relevant as they signal a potential loss in growth momentum, leading Chandan to suggest that fair value for EUR/USD based on this basis would be around 1.05.

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While a 0.5% downgrade in China's growth may only be worth 1 cent on EUR/USD, Chandan emphasized that such downgrades are typically not isolated incidents. Moreover, indicators like the Euro Area Economic Sentiment Indicators (EASIs) suggest a further loss in growth momentum in the Eurozone and China.

Factoring in these dynamics, Chandan believes that EUR/USD could reach 1.05, a level last seen in early December when China began relaxing quarantine rules.

Chandan concluded by noting that if long positions in EUR/USD are unwound, the pair could potentially reach 1.05-1.06.

Recent strength in the euro has coincided with an accumulation of long positions. JP Morgan estimates that the unwinding of these long positions could result in a 4% decline, which would bring EUR/USD just below 1.06. A move below 1.05 would require the initiation of outright euro shorts.