Financial markets are ready to switch from monetary restrictions to expansion, but central banks stubbornly refuse to agree with them. What does this mean for EURUSD? Let’s discuss this topic and make up a trading plan.
Weekly US dollar fundamental forecast
Following the US dollar, other currencies should also feel the painful effect of rate cuts by their issuing central banks. The fall in UK inflation below 5% forced the derivatives market to shift the date of BoE’s expected start of monetary expansion from July to June, which weakened the pound and put pressure on EURUSD. Central banks tend to follow the Fed. But why is it only the US dollar that suffers massive dovish reversals?
The fact that inflation is rapidly slowing in most countries suggests that its rise was caused by supply chain disruptions due to the pandemic and the war in Ukraine, as well as large-scale fiscal stimulus during COVID-19. If so, then reducing their effect should return consumer prices to prepandemic levels. It makes no sense to maintain high rates in such conditions. It is not surprising that the derivatives market predicts their decline in the eurozone from April, in the US from May, and in the UK from June.
Dynamics of market expectations for interest rates cuts
Source: Wall Street Journal.
In theory, this should weaken the euro against the US dollar and pound. However, it is the USD that will suffer the greatest losses. The Fed sets the pace for both monetary restrictions and expansions. This is why, over the past two years, when the Fed funds rate increased by 525 bps, the greenback dominated Forex. Expectations of the USD index uptrend reversal in 2022-2023 ended in failure for the bears.
Moreover, the belief that the Federal Reserve will resume its monetary tightening cycle has encouraged hedge funds to open the USD long trades over the past eight weeks. News of a slowdown in consumer prices in October triggered their exiting, which turned into the worst day for the greenback last year.
Dynamics of USD Spot Index and USD Bets Leveraged Funds
Source: Bloomberg.
The cooling of the US economy should speed up the process. In this situation, the divergence in US-eurozone economic growth will narrow, and EURUSD quotes will rise. The first contraction in US retail sales since March and producer prices since April 2020 signal that the Fed’s aggressive monetary tightening is finally yielding results.
What will the Fed do next? At first glance, the central bank is not happy with the sharp weakening of financial conditions and will maintain a hawkish stance. However, in reality, the bank is afraid of losing trust. If the Fed declares victory over inflation and then it returns, the Fed will be forced to resume raising rates. In this case, it is better to say that the fight is not over yet.
Weekly EURUSD trading plan
Investors accepted the new rules of the game. They intend to be lenient with the hawkish statements of FOMC members and use EURUSD corrections to the supports at 1.072 and 1.07 to add up to long trades. I suggest you to stick to the same strategy.
Price chart of EURUSD in real time mode
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