The Fed clearly understands the nature of inflation sustainability and clearly knows what it wants. This means that the latest FOMC forecasts are likely to come true. The market should understand this. Let us discuss the Forex outlook and make up a EURUSD trading plan.
Weekly US dollar fundamental forecast
It’s time to admit that monetary policy is no longer as strong as it used to be. Although since the beginning of the monetary tightening in September 2021, 10 G10 central banks have raised rates by 3765 basis points in total, inflation is far from their targets. Yes, consumer prices are slowing down, but the reason is the decline in energy prices. Central banks still have a lot of work to do, and investors should finally understand this.
Why is monetary policy no longer working as effectively as it used to? The monetary restriction affects the economy with a time lag. On average, it takes about 18 months. The Fed and the Bank of England started raising rates less than 18 months ago and the ECB less than a year ago. It takes time, and theoretically, it is about to come. The problem is that in the current cycle, the delay may be longer.
First, the share of the service sector in the advanced economies’ GDPs is increasing. And it is less susceptible to rate increases compared to the manufacturing sector. Second, many households have switched to fixed-rate mortgages in an era of low borrowing costs. If they were floating, the real estate sector would immediately react to the aggressive monetary restrictions by central banks. Finally, fearing a shortage of labor force in the future, employers are accumulating it today. This can be seen from the number of vacancies and employment.
If inflation is more stable, central banks need more effort to press it down. That is why the G10 central banks raised interest rates in June the fastest since the beginning of the year. At 7 out of 9 meetings, monetary policy was tightened, and the cumulative effect was +225 basis points. Only the Bank of Japan and the Fed refrained from such a step.
It may feel like the Fed is moving from decisiveness to caution. It will try to defeat inflation and ensure a soft landing for the economy. However, the central bank is well aware of the nature of price stability. The latest FOMC forecasts are convincing: 12 out of 18 officials expect the federal funds rate to rise to 5.75% in 2023. The investors do not believe since the chances of such an outcome have decreased from 36% to 30%.
I believe that the publication of the FOMC June meeting’s minutes will raise the chances of the federal funds rate hike later. The Fed needs to be hawkish. A rally in stocks and a weaker US dollar are making financial conditions less tight. The narrowing in the yield spreads of corporate and Treasury bonds also suggests the market is in euphoria. This usually indicates a more positive view of business results in the coming year.
Weekly EURUSD trading plan
Thus the Fed’s goals are clear, as well as the fallacy of market views. I suggest selling the EURUSD. The first of the two targets of 1.0835 and 1.08 for the shorts entered at 1.0965 has been reached, and a correction up allowed adding up to the sell positions.
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