In the medium term, the Fed’s policy won’t change to meet the market expectations. However, markets continue making the same mistake again and again, betting on a dovish shift. Let us discuss the Forex outlook and make up a EURUSD trading plan.
US dollar fundamental forecast for six months
Judging by the minutes of the FOMC September, many officials believe that the negative consequences of taking too little action by the Fed outweigh the consequences of going too far in monetary tightening. The central bank is more concerned that it is doing too little to curb soaring inflation than it is doing too much. Together with a strong labour market and high prices, this suggests that the federal funds rate will rise again by 75 basis points at the next meeting of the Committee. If so, the EURUSD bears will go ahead.
The determination of the Fed, which was stressed in the minutes, became the main driver of the USD index’s rise to twenty-year highs. The US dollar is currently the strongest currency. It rises amid any background. Weak domestic data bring the US economy closer to a recession, strong reports enable the Fed to continue aggressive monetary tightening, which increases the risks of a recession. Not surprisingly, the greenback is strengthening anyway. Stocks, on the other hand, perceive bad news as good news and vice versa, as evidenced by the strongest correlation between the Economic Surprise Index and the S&P 500 since 2015.
Dynamics of S&P 500 and economic surprise index
Source: Bloomberg.
Under stress, it is easier to make the wrong decision. Especially when it looks right in terms of history. A slower pace of the Fed monetary tightening, namely a 50-basis-point rate hike instead of a 75-basis-point one, may be perceived by markets as a sign that the central bank will soon stop tightening monetary policy, and possibly even turn dovish. As a result, long-term Treasury yields will go down, the S&P 500 will rise up, and the US dollar will weaken. Financial conditions, currently favoured by the Fed, will begin to ease, suggesting another round of federal funds rate hikes.
Dynamics of global financial conditions
Source: Wall Street Journal.
In the medium term, investors will still try to see the signs of the Fed’s dovish shift, which will eventually disappoint them. The S&P 500 will remain bearish as the expectation of death is worse than death itself. Stocks are falling due to fears of an imminent recession, and judging by the resilience of the US economy to the tightening of the Fed’s monetary policy, it is unlikely to come before the second or third quarters of 2023.
EURUSD trading plan for six months
Weakening risk appetite is a bearish driver for the EURUSD. The downtrend will continue, and upward corrections should be temporary. Under such conditions, it is relevant to sell on the price rise, followed by a rebound from the resistances or a breakout of the supports. I suppose the EURUSD will be trading at 0.95, 0.92, and 0.9 in one, three, and six months.
Price chart of EURUSD in real time mode
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