Because of the events in Eastern Europe, central banks face a difficult choice: to tighten monetary policy and trigger a recession, or to pause, which will turn into stagflation. The choice of the ECB is especially difficult. Let us discuss the Forex outlook and make up a EURUSD trading plan.
Weekly US dollar fundamental forecast
According to the dollar smile theory, the greenback strengthens during a recession because of the high demand for safe-haven assets, then goes down because of the large fiscal stimulus provided by the Fed after which it rises again because the US economy outperforms others. Prior to the events in Eastern Europe, the USD index was about to start falling, but the conflict supported the greenback uptrend.
When the stock market is falling, the Treasury yield curve is about to invert or the oil prices are skyrocketing, few would panic about the recession. But when all these events occur simultaneously, the threat of a recession should be taken more seriously. The Dow Jones last faced a correction in February 2020 and the Nasdaq Composite was being sold off in March 2020. Now they are again 10% and 20% down from the previous highs. Brent topped $130 a barrel amid the talks about a ban on Russian oil imports, and only Germany’s resistance set the bulls back. The rate differential between 10 and 2-year Treasuries, known as the yield curve, has hit its lowest point since the pandemic recession. The 10-2 year Treasury yield spread, referred to as the yield curve, has been the lowest since the pandemic recession.
Globally, financial conditions are deteriorating, which means an economic downturn. Amid soaring energy prices, falling equity markets, and worries about the negative impact of the war in Ukraine on global GDP, financial conditions are the tightest in two years. They reflect the impact of exchange rates, fluctuations in the capital and borrowing costs on the funding available in the global economy. All the above is a bullish driver for the US dollar.
Central banks are facing a hard choice. Aggressive monetary tightening could result in a recession, while a too slow process will lead to stagflation. The latter is especially acute in the euro area. Germany’s wages growth rate last year has been the slowest (+1.3%) since 2010, while in the US the indicator has been up by 5% or more over the past few months. Existing job retention programs in Europe provide little opportunity to increase wages, unlike in the USA, where the market is more flexible.
Weekly EURUSD trading plan
The ECB officials understand that most of the inflation growth is associated with energy prices, the supply, which the central bank cannot influence. Therefore, even the Governing Council’s hawks start talking about a delay in monetary tightening. Before the war in Ukraine, investors expected the ECB to provide some clues about the end of the QE at the March meeting; now, nobody believes in a soon quantitative easing taper. The ECB monetary policy will hardly be changed. Thus, it is still relevant to sell the EURUSD towards 1.0655.