The Federal Reserve has become an innovator in 2020-2021, but the market continues to live the old-fashioned way. Investors still do not believe in the willingness of the central bank to allow the economy to overheat and test the Fed for strength. Should we expect new tests similar to March? Let us discuss the Forex outlook and make up a EURUSD trading plan.
Weekly US dollar fundamental forecast
The weak German business climate index, the dovish stance of the ECB officials, and the hawkish shift in the forecasts of Bloomberg experts concerning the start of tapering the US QE didn’t allow the EURUSD bulls to consolidate the price at the bottom of figure 21. Nordea Markets notes that the markets underestimate the possibility of a quick return of unemployment to pre-pandemic levels, the ability of inflation to stay above 2% for a long time, and the risks of an earlier start of the Fed’s monetary policy normalization. If so, it’s time to buy the US dollar. If everything were so simple …
Investors’ behavior has been shaped for decades and passed down from generation to generation. The world economy develops cyclically: the recession is followed by the recovery and vice versa. The central bank should give and take monetary stimulus to smooth out the recession and prevent the following overheating. First, this leads to a weakening of the greenback, then – to its growth. The problem with the current recession is that it is unique. The US economy is recovering much faster than usual. However, the return of global GDP to the trend is uneven due to different rates of vaccination. In this regard, the Fed’s position is significantly different from what generations of investors have seen in previous decades. The Fed is willing to put up with the high inflation, allowing the economy to overheat, as it considers these processes to be temporary. Nonetheless, it is tough to change the market expectations.
Investors’ expectations stick to the old patterns. Traders tend to overestimate the chances of a federal funds rate hike because if it happens sooner rather than later, they could lose money on bonds. This is especially true when borrowing costs are near historically low levels.
Dynamics of Fed interest rate and expected changes implied by market sentiment
Source: Wall Street Journal
As a result, there are so-called tests of the Fed’s strength. There was an illustrative example in March. Treasury yields were rallying up even though Jerome Powell and his colleagues persistently repeated the mantra about the Fed’s willingness to remain passive for a long time. In April, the Treasury yields went down, depriving the US dollar of its competitive advantage, but the market may not have calmed down. Such tests of strength will repeat, especially since the US economic growth is meeting the expectations.
What am I driving at? EURUSD bulls must be ready for drawdowns. And the corrections should be deep enough. But I strongly doubt that the medium-term downtrend will resume. That is because the euro is not at all the same as in the first quarter. The EU is increasing the vaccination speed. Although not as massive as in the United States, the euro-area fiscal stimulus is coming into effect. The stimulus effect will be the most in 2021 and will not be distributed between years.
Weekly EURUSD trading plan
The USA is losing its exclusivity, and other advanced economies are recovering. Therefore, I recommend buying the EURUSD on the rebounds from the supports at 1.2044, 1.2 and 1.1965. The signal to open long positions will also be the euro corrections down after the publication of the euro-area and US GDP data for the first quarter and the FOMC meeting.
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Price chart of EURUSD in real time mode
The content of this article reflects the author’s opinion and does not necessarily reflect the official position of LiteForex. The material published on this page is provided for informational purposes only and should not be considered as the provision of investment advice for the purposes of Directive 2004/39/EC.