What is dollar afraid of? Forecast as of 31.01.2022

The derivatives market believes that the Fed’s rate will increase in 2022 not by 75 basis points, as the FOMC December forecast suggests, but by 125 basis points. This circumstance supports the US dollar rally. What could discourage the EURUSD sellers? Let us discuss the Forex outlook and make up a trading plan.

Weekly US dollar fundamental forecast

The Fed’s unwillingness to pay attention to the collapse of US stock indexes and the ECB’s intention to protect the European bond markets from global turmoil allowed the US dollar to mark its best weekly rise against the euro in the last seven months. The return of investors to the greenback after Jerome Powell’s hawkish speech at the end of the FOMC January meeting played a significant role. The day before, speculators reduced USD longs against six major world currencies to the lowest level in 21 weeks. As soon as the ballast was thrown out, the US dollar has been rising.

In early 2022, the derivatives market signaled three interest rate hikes, but at the end of January, the probability of four hikes is more than 90%, five — 67%. JP Morgan predicts monetary tightening at five FOMC meetings in 2022, while Bank of America says there will be seven increases in borrowing costs. Deutsche Bank recalls that, on average, in the first year of rate hikes, they have risen by just under 250 basis points in monetary tightening cycles since 1973. The Fed’s latest forecasts for borrowing costs to rise from 0.25% to 1% in 2022 are obviously underestimated.

However, derivatives still insist on a short cycle: they expect the federal funds rate to end at 1.75%. This is lower than the FOMC estimates. Such signals are due to the stability of inflation expectations. The good news for the Fed is that it will quickly regain control of inflation; the bad news is that a quick monetary tightening cycle could damage the US economy.

It seems that the Fed pays no attention to the US stock market and tightening financial conditions. According to Powell, the stock indexes decline is a natural reaction to the reduction in monetary stimulus and does not threaten the US economy. Because of the massive support from the central bank, the S&P 500 rose 114% from its March bottom in 2020 to its all-time high on January 3. Since the beginning of the year, it has sunk by 8%, and there is an assumption that the price will continue falling.

According to Barclays, it is the correction of the US stock market and the associated increase in the volatility of the financial markets that will become the main driver of the dollar strengthening in the near future because the factor of five federal funds rate increases in 2022 has been already priced in its quotes. I beg to differ. The Fed may surprise with a 50-basis-points rise in borrowing costs in March, as Atlanta Fed President Raphael Bostic suggests. If the tightening of monetary policy does not help slow down inflation, I would not rule out six or seven rate hikes.

Weekly EURUSD trading plan today

Therefore, the EURUSD medium-term outlook remains bearish. However, the greenback could go down in the short term, as investors are concerned about growing risks of a negative change in the US nonfarm payrolls, projected by Jefferies, Pantheon Macroeconomics, and other companies. I expect the major currency pair to jump up and down in the week ending February 4. The euro could be corrected if the support at 1.1175 is broken out.

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