The divergence in monetary policies of the Fed and the ECB result from different inflation levels and the different paces of labour markets recovery. How will this affect the EURUSD? Let us discuss the Forex outlook and make up a trading plan.
Weekly US dollar fundamental forecast
In the spring of 2020, central banks were actively introducing large-scale monetary incentives due to the pandemic. However, at the end of 2021, the regulators are willing to aggressively tighten monetary policies amid the appearance of the new COVID-19 variant. Is it a paradox? No, it isn’t! In 2020, regulators were more concerned about saving their economies from recessions, and now they worry about high inflation. Will the inflation rate remain high for a long time or start slowing down in the second half of 2022? Nobody knows the correct answer to this question, which means that the Fed and other central banks need to be fully armed.
The government’s imposition of lockdowns in the first half of 2020 caused a greater contraction in demand than in supply, which pressed down prices at first, leading to a deflationary environment and recession. Currently, the economy has adapted to the pandemic, demand has recovered quite quickly, and supply may be further pressed down by the omicron. This environment is inflationary. As a result, central banks have to change their strategy.
Prices in English-speaking countries are growing faster than, for example, in continental Europe, which explains the different approaches of regulators to monetary policy. For comparison, core inflation in the euro area is 2.6%, in the UK – 4%, in the United States – 4.6%.
Furthermore, labour markets are also recovering at different rates. The ECB feels more relaxed than the Fed or the Bank of England, as wages are growing slower in the euro area than in the USA or the UK. As a result, the Fed’s hawks are going ahead, while Christine Lagarde and her colleagues still sound dovish.
The euro’s initial growth following the ECB December meeting results resulted from the rise in the European bond yields. The Governing Council decided to reduce the volume of asset purchases from the current €80 billion per month to €40 billion from April, € 30 billion from June, and finally to € 20 billion from October. The large buyer exits the bond market, which presses down the prices and pushes up the yields, supporting the EURUSD. However, the bulls didn’t enjoy their success for long.
The ECB continues QE, and the Fed intends to complete the program in March. The ECB is not going to raise rates in 2022, and the Fed will bring them to 1%. In such an environment, the euro-dollar sellers will go ahead, using the growth of the major currency pair to enter sell trades. The EURUSD risk reversals have reached the most bearish level over the past eighteen months, and Barclays expects the price to fall deeper.
Weekly EURUSD trading plan
I won’t say all greenback’s advantages have been exhausted. The derivatives market predicts an increase in the federal funds rate to 1.5% in 2024, although the FOMC forecast suggests it will rise to 2.1%. In addition, the discussions about the timing of the first rate hike will be of great importance in the near future. Not surprisingly, Christopher Waller’s announcement that the first increase in the Fed’s rate will occur in March has pressed the EURUSD down to 1.124. If the price fails to go above 1.1255, signaling the bulls’ weakness, it will be relevant to sell.