Although the EURUSD is up to the bottom of figure 16, the downtrend will hardly turn up. The approaches of the Fed and the ECB to monetary policy look too different. How will the divergence affect the euro? Let us discuss the Forex outlook and make up a trading plan.
Weekly euro fundamental forecast
The ECB spent much of the past decade struggling to avoid Japan-style deflation, and its reluctance to raise rates is nothing more than an echo of the past. Philip Lane, the European Central Bank’s chief economist, noted that the euro-area consumer prices had averaged 0.9% from 2014 to 2019. Therefore, based on the policy of symmetric inflation, even at the current level of 4.1%, it does not reach the European Central Bank’s target of 2 %. Lane believes it is counter-productive to tighten monetary policy at the current juncture.
Not so long ago, Christine Lagarde said that the three criteria required for a rate hike would not be met next year. The dovish tone of the ECB President, despite the rumors spread by the media about an alleged split among the ECB members, makes monetary policy more than transparent. The Fed’s position is radically different. More flexible labour and housing markets in the United States compared to the euro area increase the risks of a self-sustained wage-price spiral forcing the Fed’s officials to sound hawkish.
According to the Federal Reserve Bank of New York, US inflation expectations for the year ahead increased to a new record high of 5.7% in October of 2021. Three-year-ahead inflation expectations are up to 4.2%. These are the highest levels since the inception of the survey in 2013.
Dynamics of US inflation expectations
In such an environment, it is the right thing to suggest monetary tightening. The Vice Chair of the Federal Reserve, Richard Clarida, has said the “necessary conditions” for interest rates to rise will be met by the end of 2022. The unemployment rate will drop to 3.8% from its current level of 4.6%, as projections suggest, and the inflation rate will be slightly above the target of 2%. St. Louis Federal Reserve Bank President James Bullard has said he expects the Fed to raise interest rates twice in 2022, as job markets are already so tight that it is adding to inflation through growing wages.
Therefore, the Fed and the ECB stick to completely different views on interest rates, and the divergence in monetary policies is to support the EURUSD bears. The euro-dollar downtrend looks strong, as is clear from the instruments of bond and derivatives markets. Based on interest rate swaps, the euro will continue falling.
Dynamics of EURUSD and interest rate swap spread
Source: Nordea Markets
Weekly EURUSD trading plan
Any trend is accompanied by a correction. The S&P 500 has hit its all-time high for the eighth session in a row, and the real Treasury yield is down, which encourages the EURUSD bulls to go ahead in the short run. Nonetheless, this doesn’t affect the medium- and long-term prospects of the euro-dollar. It is still relevant to sell the euro versus the US dollar on the price rise followed by a rebound from the resistances at $1.161 and $1.1625. A fundamental reason to enter EURUSD shorts will be strong US inflation data for October.
Price chart of EURUSD in real time mode
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