Even if the Fed tightens monetary policy so aggressively that the US economy enters a recession, the US dollar may still find support. According to the Dollar Smile Theory, the greenback can strengthen anyway. Let’s examine the situation and develop a trading plan for the EUR/USD.
The article covers the following subjects:
Major Takeaways
- A yield curve inversion is approaching.
- The market expects the Fed to raise rates to 4.75%.
- Oil prices are holding steady despite rising supply.
- Short trades can be opened with targets of 1.13 and 1.12.
Weekly Fundamental Forecast for Dollar
The derivatives market is pricing in a federal funds rate increase of at least 75 basis points, prompting investors to question whether the US economy can withstand such tightening. The spread between 10-year and 2-year US Treasury yields is approaching inversion, a development that has historically been associated with elevated recession risks. According to the Dollar Smile Theory, the US dollar can strengthen in two contrasting scenarios: when economic conditions are strong and when global or domestic conditions deteriorate sharply. Against this backdrop, concerns about a potential downturn may be adding to downward pressure on the EUR/USD.
US Yield Curve
Source: Bloomberg.
On average, 15 months elapsed between a yield-curve inversion and the onset of a recession. The longest lag was three years, while the shortest was just five months. In some cases, a recession was avoided, as happened in 1998 and 2022. This has led to a famous quip, “the stock market has predicted nine out of the last five recessions.”
Given the strength of the labor market, substantial investment in artificial intelligence, rising productivity, the wealth effect, and improving PMI readings, a sharp downturn in the US economy does not appear imminent. However, markets are clearly pricing in a faster pace of monetary tightening relative to economic growth. For now, this dynamic favors EUR/USD bears. If US macroeconomic data begins to deteriorate, however, the risk of a pullback in the currency pair could increase.
The recent decline in the EUR/USD has been influenced in part by differences in the pace of monetary tightening. The derivatives market has priced in a 73% probability of a federal funds rate hike at the next FOMC meeting, compared with a 31% probability of an ECB deposit rate hike. The latter probability has fallen significantly following Christine Lagarde’s comments emphasizing the need to balance the risks of higher inflation against the potential slowdown in economic growth. Lagarde also noted that she did not yet see evidence of elevated energy prices feeding through into core inflation.
Euro Area Inflation Rate
Source: Bloomberg.
The ECB is exercising caution, partly because of growing political risks. At the same time, nearly every FOMC official has emphasized the need to continue monetary tightening. This divergence in policy expectations is driving the EUR/USD down.
Adding to the uncertainty is the rally in Brent crude. Traffic through the Strait of Hormuz is increasing, Saudi Arabia is expanding the use of its East-West pipeline, and global supply is rising, yet oil prices continue to climb. This raises questions about whether markets are anticipating a potential escalation in geopolitical tensions. Higher oil prices could add to inflationary pressures and, in turn, increase pressure on the Fed to maintain a restrictive monetary policy stance.
Weekly Trading Plan for EUR/USD
Meanwhile, the EUR/USD pair is still likely to reach its targets of 1.13 and 1.12. As a result, consider short positions.
This forecast is based on the analysis of fundamental factors, including official statements from financial institutions and regulators, various geopolitical and economic developments, and statistical data. Historical market data are also considered.
Price chart of EURUSD in real time mode
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