The divergence in monetary policies is the most powerful Forex driver. Trade wars, pandemics, and elections come and go, but the monetary policy continues to affect the foreign exchange rates. How do central banks’ interest rates affect the EURUSD? Let us discuss the Forex outlook and make up a trading plan.
Quarterly US dollar fundamental forecast
In the middle of the year, when EURUSD was trading above 1.18, I stated that the price was more likely to go down to 1.14 than to return to 1.22, and many would oppose. At that time, the euro uptrend against the US dollar, and the price drop looked like just a correction. I was convinced that the bet on the divergence in the monetary policies of the Fed and the European Central Bank should work. And it has worked!
It is hard to expect the ECB to sound hawkish when the euro-area economy has been about to slide into deflation for most of the last decade. From 2014 to 2019, consumer prices grew by an average of 0.9%, and if we consider the current surge above 4% as a temporary phenomenon, Christine Lagarde and her colleagues clearly should not rush to raise rates. Especially in 2022, as the money markets expect. Furthermore, the European Commission forecasts the euro-area CPI will slow down to 1.4% in 2023. If it turns out to be wrong, monetary policy could be tightened later that year. In the meantime, the ECB should replace the emergency purchase programme, which expires in March, with its regular quantitative easing programme, APP.
Yes, the ECB may raise the deposit rate by the end of 2023, but the Fed could raise the federal funds rate six times by that time. If so, there must be a huge gap between the US and German bond yields, which for years has been an indicator helping analysts predict the EURUSD trend. For example, Nordea Markets expect to see the euro-dollar at 1.085 at the end of 2022. Based on the risk reversals, the forecast doesn’t seem unreal.
Dynamics of bond yields spread and risk reversals
The derivatives market has already made up its own schedule for the Fed’s rate changes. It is expected that the federal funds rate will be hiked in July, September, and December. The likelihood of the third rate hike in 2022 is still fifty-fifty, but it may increase if inflation continues to accelerate. Based on changes in wages, rents, and other indicators, US inflation will continue rising! If so, there could be another three rate hikes in 2023.
The Federal Reserve still repeats its mantra about the temporary nature of high inflation, although it has begun to admit that this period will be longer than previously thought. It is suggested consumer price growth should slow down by mid-2022. But the US inflation will still be above the 2% target. The return of the US economy to full employment will force the central bank to tighten its monetary policy.
Quarterly EURUSD trading plan
Therefore, the EURUSD downtrend is strong and stable. Any price rises should be interpreted as corrections. The euro will hardly become more appealing to investors than the dollar. It is still relevant to sell the EURUSD on the corrections. The downside targets are at 1.133 and 1.122.
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.