Historically, the start of the Fed’s monetary restriction is bad news for the US dollar. Most of the positive has been priced in the USD, and the dollar should be falling on the facts. Will the story happen now? Let us discuss the Forex outlook and make up a EURUSD trading plan.
Weekly US dollar fundamental forecast
If history were to repeat itself over and over again, investors should be selling the dollar right now. The experience of the previous Fed’s monetary tightening cycles shows that the greenback strengthened during the nine months before the first federal funds rate hike, and then its price fell by an average of 4.1% during the course of monetary restriction. All this has much in common with what is happening at the present time. The USD index has been 7% up in the past nine months, and hedge funds that know the history have been selling the US dollar against eight major world currencies for four weeks in a row. However, this time the old pattern may not work.
US dollar’s response to Fed’s monetary tightening cycles
For decades, investors have dealt with one key driver of price changes in various assets, whether it be a trade war or a pandemic. COVID-19 triggered a recession and the Fed responded with massive monetary stimulus. This set the stage for a reflation trade, combining rising consumer prices and strong GDP growth. The Fed had remained passive for a very long time, claiming that the surge in inflation is temporary. As a result, the Fed faced the risk of being too late, and in order not to lose control over CPI and PCE, it was forced to aggressively tighten monetary policy.
The scheme was transparent and understandable, but now there is the conflict in Ukraine and the largest outbreak of COVID-19 in China. They threaten with recession and stagflation, disrupt many intermarket links, and make markets’ movements chaotic. A mixture of various factors suggests the simultaneous return of the 1970s when the Fed struggled with the highest inflation, the 1980s when emerging markets faced a series of defaults, and the 1990s when rising bond yields scared the markets.
In my opinion, it is the uncertainty due to many important drivers that will allow the US dollar not to repeat the sad history of weakening amid the Fed’s monetary tightening. It is uncertainty, rather than the expectations of the Fed’s faster monetary restriction cycle compared to other central banks, which is expressed in the widening differential in the rates on the US bonds and other assets compared to foreign peers.
Dynamics of USD and differential in swap rates
Weekly EURUSD trading plan
The Fed has no reason to start the monetary restriction cycle aggressively and raise the federal funds rate by half a point right away, but in the future, such a move may be required. Jerome Powell has hinted at something like this, and the FOMC has changed the forecasts for the rate hikes. In December, the policymakers expected three increases in borrowing costs in 2022, while in March, they suggest six or seven. The above factors could encourage the EURUSD bears. Still, the main advantage of the greenback is uncertainty, rather than divergence in monetary policies. Therefore, I recommend selling the euro against the dollar if the price breaks out the supports at 1.09 and 1.088 or rebounds down from resistances at 1.105, 1.107 and 1.111.
Price chart of EURUSD in real time mode
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