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Dollar is into geopolitics. Forecast as of 15.02.2022

Christine Lagarde speaks of patience again after the ECB February meeting, and EURUSD returns to the levels that took place on the eve of the meeting. Has the ECB president discouraged the markets or the major currency pair is falling for a different reason? Let us discuss the Forex outlook and make up a trading plan.

Weekly US dollar fundamental forecast

Ukrainian President Volodymyr Zelenskyy predicts Wednesday will be the day of the attack. The White House decided to move the US embassy staff from Kyiv to Lviv, away from Russia and closer to Poland. These factors triggered a wave of sell-offs in the US stock market. Investors were worried about rising energy prices and the risks of a slowdown in the euro-area GDP due to a military conflict in Eastern Europe, and the euro returned to the levels from which it started during Christine Lagarde’s speech following the ECB February meeting. The ECB hawkish pivot didn’t work out; the ECB president convinced investors in maintaining the central bank’s ultra-easy monetary policy. However, the primary reason for the EURUSD drop is geopolitics.

According to Capital Economics, the war between Russia and Ukraine will drive up inflation in advanced economies to 4.5% due to rising energy prices. JP Morgan expects the global CPI could reach 7% if Brent soars to $150 per barrel as a result of the conflict. Although central banks tend to ignore the energy component of consumer prices, they are now so worried about the risks of mistakes, that they may aggressively raise rates, fraught with another global economic recession.

This is a pessimistic scenario. In fact, even in the case of a Russian invasion of Ukraine, which I think is unlikely, geopolitics will have a short-term impact on financial markets. According to CFRA research, 24 post-World War II events caused the S&P 500 to drop an average of 5.5% from high to bottom. The market took 24 days to reach a low and 28 days to recover.

I suppose markets overreact to potential geopolitical risks. The success of Olaf Scholz’s double mission in Kyiv and Moscow, together with a slowdown in the US inflation, could support the EURUSD bulls. According to a survey released on Monday by the New York Federal Reserve, one-year inflation expectations decreased to a median of 5.8% in January from 6.0% in December; inflation expectations three years out declined to 3.5% from 4.0%. The Fed’s hawkish tone seems to have worked out, so the central bank may not need to tighten its monetary policy aggressively.

According to Kansas City Fed President Esther George, it is always preferable to proceed gradually. Given the uncertainty associated with the pandemic and other events, she can’t justify the need for a quick transition to a neutral rate. Although Bullard argues that the slow tightening of monetary policy will undermine confidence in the Fed, the markets no longer believe him. In my opinion, the Fed will make an error if it raises the rate by half a point in March. Aggressive tightening could result in a recession, as signalled by the flattening of the US yield curve.

Weekly EURUSD trading plan

I still count on German diplomacy and believe markets overestimate the speed of the Fed’s monetary tightening, expecting six rate hikes in 2022. If the EURUSD closes the day above 1.1315 and 1.136, one could consider entering longs.

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