USD evaluates risks. Forecast as of 27.12.2022

Forecasting is a thankless occupation. Especially if serious mistakes were made while performing it. Investors should not react violently to new estimates and forget tail risks. Let’s discuss this topic and make up a trading plan for EURUSD.

Weekly US dollar fundamental forecast

Only those who do nothing never make any mistakes. However, both the markets and the Fed made a serious mistake a year ago when forecasting 2022 events. Therefore, in 2023, everything may be completely different from what they predict. The Fed sees an increase in the federal funds rate to 5.25% and maintaining this level at least until the end of next year. Investors believe the rate ceiling is lower, and at the end of 2023, it will fall by 50 bps from its high. If both are wrong, is a third option possible?

At the end of last year, Fed officials believed that inflation would slow down on its own and there would be no need to raise rates by more than 75-100 bps. In fact, consumer prices accelerated to 40-year peaks, and the cost of borrowing has increased by 425 bps. In 2023, Jerome Powell and his colleagues expect inflation to slow down to 3-4% and the federal funds rate to rise above 5%.

Wall Street analysts predicted that 2022 would not be too good for the S&P 500. However, the stock index is likely to drop by 19%, which will be its worst performance since 2008. What is the reason for such significant discrepancies between forecasts and the real situation? Most likely, the reason is the underestimation of tail risks. These seem unlikely events, but when they happen, it changes the balance of power in the markets. Such risks in 2022 were the war in Ukraine and COVID-19. In 2023, this list will change.

Investors are very afraid of a new inflation high. Currently, prices are slowing down, but what if they go up again? The Fed will start raising rates aggressively again, supporting the US dollar.

The second most important tail risk is a deep and prolonged recession in the global economy. Many are expecting a soft landing or a short, slight decline. Otherwise, the Fed will be forced to turn dovish and fuel financial markets with cheap liquidity, which will cause the USD to decline.

There are risks that central banks will turn more hawkish and adopt a selective policy. In particular, ECB officials Klaas Knot and Isabel Schnabel argue that the central bank has done only half the work, and the markets underestimate the peak rate of deposits. Such statements support EURUSD.

Worsening geopolitical tension is another tail risk. The escalation of the armed conflict in Ukraine or the war in Taiwan can deal another blow to the global economy and increase the demand for safe-haven assets, including the USD.

Weekly EURUSD trading plan

Nothing has been lost yet for EURUSD bears. If one or more unlikely events happen, they will go ahead. In the meantime, investors expect a Santa Claus rally and are considering euro purchases on a breakout of resistance at $1.0655.

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