Dollar looks for a way out. Forecast as of 26.05.2022

The ECB’s passive attitude sent the EURUSD down to five-year lows, and investors spoke about parity. Once the Governing Council’s official suggested active steps, the situation has radically changed. Let us discuss the Forex outlook and make up a trading plan.

Monthly US dollar fundamental forecast

ECB is trying to catch up while the Fed is looking for a way out. The EURUSD is naturally rallying up. Markets change the worldview. Traders understand that the euro at $1.04 is too low and at $1.1 is too high. The European Central Bank faces a much more difficult task than the Fed because the supply shock in the euro area is much greater than in the US. And this circumstance will hinder the regional currency from strengthening.

Governing Council officials support Christine Lagarde’s idea to get the deposit rate out of the sub-zero area by the end of September. ECB Vice-President Luis de Guindos says the plan looks reasonable, while the Chief Economist Philip Lane called it clear and strict. Klaas Knot notes that he fully supports everything that is in Lagarde’s blog. A half-a-point rate hike at one of the ECB meetings is not ruled out as it doesn’t contradict the plan.

Despite the hawkish speeches of Christine Lagarde and her fellow central bankers, the ECB is lagging behind the Fed. According to the FOMC May meeting minutes, the Fed intends to raise the federal funds rate by half a point at each of the next two meetings, in June and July. Moreover, the Fed is unwinding the balance sheet while the ECB is not willing to start shrinking its balance sheet. According to the ECB Executive Board member Fabio Panetta, the regulator does not need to risk unsettling financial markets via a passive runoff or active sales of bonds held on the balance sheet, given that the policymakers have other tools. Klaas Knot does not expect a discussion on this issue until at least the end of the year and suggests focusing on the interest rates.

Unwinding the balance sheet at the pace planned by the Fed is equivalent to raising the federal funds rate by 0.5-1 percentage point. Considering assets withdrawal, it could rise to 4.5% by mid-2023. At the same time, the ECB deposit rate in the same period will not rise higher than 1.5% as the central bank is to maintain the balance sheet at €8.8 trillion. If so, why is the EURUSD rallying up?

Most of the greenback bullish drivers have been already priced in its quotes, and the USD was up to 20-year highs before the ECB stepped in. Now, investors are concerned about a pause in the Fed’s monetary tightening, pressing down the US dollar. Based on the FOMC May meeting, aggressive monetary tightening at the beginning of the cycle would create favourable conditions to assess the consequences at the end of the year.

Monthly EURUSD trading plan

The transparent policies of the world’s leading central banks allow me to see the EURUSD support in $1.05-1.06. It means the purchases above 1.06 look reasonable. However, the euro uptrend also has resistance in $1.08-1.09. If the rally continues, but the euro rebounds from the resistance levels of $1.083 and $1.088, it will be relevant to sell the pair.

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