EUR/USD: Will The Dollar Hit The Brakes?

Forming positions in the EUR/USD depending on changes in the position of the Fed.

With the slow recovery of the world economy from the crisis, low inflation and financial markets addicted to large-scale injections of liquidity, even a small increase in the federal funds rate can cause serious shocks. Over the past three years, the Fed has tightened monetary policy eight times, increasing borrowing costs from zero to 2.25%. In 2004-2007, the central bank did it 17 times, raising the rate from 1% to 5.25%. And if the previous normalization cycle did not lead to a change in the uptrend in the US stock market, then a more than 10% drop in US stock indexes from the highs of 2018 indicates that monetary restriction is going too fast.

The Fed rate dynamics

Source: Wall Street Journal.

The lower the S&P 500 falls, the more enraged Donald Trump is. The President of the United States does not cease to criticize the Fed, and representatives of the American administration point out that he is not entirely unreasonable, but at the same time no one encroaches on the independence of the central bank. Following the statement about the inconsistency of the Fed’s actions against the background of low inflation, a fire in Paris and China falling to its knees, there was a fiery speech about the threat of a strong dollar, the dynamics of which is a good reason for a pause in the normalization cycle, and appeals to stop reducing the balance by $50 billion a month. The markets already face a lack of liquidity, why aggravate the situation?

The leader of the White House needs a scapegoat, as we have already said. The Fed continues to ignore the criticism of Donald Trump and refrains from commenting, but the fact that, on the eve of the meeting, the derivatives market reduced the likelihood of a federal funds rate increase to 2.5% from 78% to 70%, heightens the risks of Jerome Powell’s dovish rhetoric. Currently, markets expect forecasts to deteriorate (instead of three acts of monetary restriction in 2019, the Fed will most likely indicate two), changes in the wording of “gradual normalization” to “dependence of decisions on incoming data” and maintaining the previous scale of balance reduction. Let me remind you that the central bank does not reinvest the income from bonds to be redeemed for the amount of $50 billion a month. As a result, its assets are reduced, unlike the assets of the ECB or Bank of Japan.

Dynamics of balances of central banks

Source: Wall Street Journal.

According to Citigroup, the US dollar cannot weaken after the FOMC meeting, since all the above negative from the dovish position of the Fed has already been priced in its quotes. A significant fall in the USD index requires the rate to stay unchanged at 2.25%. Looking at the dynamics of the currency pairs associated with the greenback on the eve of the regulator’s meeting, you understand that there is some truth in this, because the markets are rising on rumors and falling on facts. The EUR/USD rally to the top of the 13th figure is due to insinuations about the changes in the Fed’s worldview. If it retains his former views, the dollar will quickly recover losses. The actual slowdown of the normalization cycle will allow the euro bulls to count on a quick test of resistance at $1.1445.

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