Investors knew that the Fed would begin unwinding the $8.9-trillion balance sheet, but they didn’t expect it so soon! In 2017-2019, the balance sheet reduction took the Fed almost two years from the moment of the first rate hike, now this period can be reduced to two months. How will this affect EURUSD? Let us discuss the Forex outlook and make up a trading plan.
Weekly US dollar fundamental forecast
When the Fed moves from words to deeds, markets are shaking. The minutes of the last FOMC meeting showed that the policymakers could vote for a 50-basis-point increase already in March, but the uncertainty associated with the events in Ukraine set them back. However, many of them intended to make a big move in May if inflation continues growing, and the Fed is now ready to act. However, investors were shocked not by the rate hike but by the balance sheet reduction.
The US Central Bank has already implemented QT, quantitative tightening, by shrinking its asset portfolio. This happened in 2013, resulting in the taper tantrum, and in 2017-2019 when the market turmoil was averted. In the latest episode, the Fed spent a long time preparing investors for the balance sheet shrinking not to repeat the previous mistakes. This time markets knew that there would be a QT, but they didn’t expect it so soon!
Last time, there were almost two years between the first rate hike and the beginning of the asset portfolio shrinking. Now, the Fed is willing to start it right away and launch the QT at the next meeting following the start of the monetary tightening cycle. In 2017-2019, the scale of the program was $50 billion per month, and it took the Fed about a year to bring it up to this figure, starting from $10 billion. In 2022, the QT could be $95 billion per month right away. So, the taper tantrum of 2013 could well repeat now. No wonder the markets are reacting so violently – Treasury yields and the US dollar are rising while the stock indexes are falling.
Dynamics of Fed balance sheet
Source: Wall Street Journal
Dynamics of US Treasury yields
Source: Wall Street Journal.
According to Thomas Barkin, president of the Richmond Fed, a 50-basis-point interest rate increase has been decided. The Fed has done this before, why not use past experience to curb inflation expectations?
At the same time, the factor of aggressive monetary restriction was mostly priced in financial markets. Investors hoped that the Fed wouldn’t act that aggressively amid a gradual slowdown in the inflation rate and the growing risk of a recession. However, the pandemic outbreak in China, associated with new supply chain disruptions, could result in a longer period of high inflation than currently anticipated. The US central bank may tighten monetary policy for a very long time, which is good news for the US dollar. 37 out of 53 Reuters experts predict that the greenback dominance will last at least three months. 17 of them expect 6 months or more. Only three economists believe that the era of the strong dollar is over.
Weekly EURUSD trading plan
I don’t think the taper tantrum of 2013 will repeat. If the EURUSD goes up above the resistance of 1.094, one could consider entering longs with moderate targets. If the pair drops below 1.088, the downtrend should continue.
Price chart of EURUSD in real time mode
The content of this article reflects the author’s opinion and does not necessarily reflect the official position of LiteFinance. The material published on this page is provided for informational purposes only and should not be considered as the provision of investment advice for the purposes of Directive 2004/39/EC.