The EURUSD rally is going too fast as the market keeps pushing back the Fed’s dovish reversal dates. Isn’t it overreacting? Let’s discuss this topic and make up a trading plan.
Weekly US dollar fundamental forecast
Why is the US dollar falling so quickly? There are three main reasons. Firstly, after the release of inflation data for October, markets lost faith in increasing the federal funds rate and expect it to be reduced in 2023. Secondly, the economy is cooling, which deprives the greenback of such an advantage as American exceptionalism. Finally, the stock market rally indicates an improvement in global risk appetite, which is good news for EURUSD.
The derivatives market is currently pricing in expectations of a 100 bps cut in the federal funds rate to 4.5% by the end of 2024. However, following weak UK retail sales and European industrial production data, derivatives are forecasting similar cuts in borrowing costs by the Bank of England and the ECB next year.
Dynamics of market expectations for Bank of England and ECB rates
Source: Financial Times.
The fact that the expected timing of the Fed’s first act of monetary expansion is moving earlier is a problem for the US dollar. Markets are now choosing between May and March. And between July and June for the UK and the eurozone, which is surprising. The American economy looks stronger than the European ones, so the Federal Reserve can afford to hold rates longer than the ECB or the BoE.
Another thing is that a series of disappointing US data releases gives reason to talk about a reduction in US-eurozone divergence in economic growth. This advantage has helped EURUSD bears for a long time. After an impressive 4.9% gain for US GDP in the third quarter, the divergence and the USD index likely peaked.
Global risk appetite began to improve after it became clear that the armed conflict in Israel would not spread to the entire Middle East. Then, slowing inflation in the US, eurozone, and UK increased the chances of dovish reversals by the world’s leading central banks. Belief in monetary stimulus suggests a soft landing, creating an ideal environment for stock indices.
US dollar and S&P 500 dynamics
Source: Trading Economics.
However, according to Wells Fargo, there will not be a soft landing. Either a strong economy will lead to a new round of inflation, forcing the Fed to resume its monetary tightening cycle and leading to a recession. Or the GDP slowdown will end in recession. Interestingly, according to Deutsche Bank, during the last 11 monetary restriction cycles, on average, there were about two years between the first increase in the federal funds rate and a recession. This time, the Fed started in March 2022. Will the US economy really face a recession by the spring of 2024?
Weekly EURUSD trading plan
It is no longer possible to shift the dates of the first monetary policy easing by the Fed. Therefore, if US stock indices take a break, the same will happen with EURUSD. The failure of the major currency pair to overcome the resistance at 1.094, or its fall below 1.089, will increase the risks of consolidation and provide an opportunity to sell the euro in the short term.
Price chart of EURUSD in real time mode
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