After inflation ceased to be the primary concern, investors shifted their attention to the economy. It turns out that the United States can outperform anyone: the eurozone and the UK are mired in stagflation, and China—still slowly recovering from the pandemic. As a result, the U.S. dollar has become the cleanest shirt in a basket of dirty laundry and is confidently positioning itself ahead of the September meeting of the Federal Reserve. Can the Federal Reserve scare the "bears" on EUR/USD?
After successful years for the U.S. dollar in 2021 and 2022, 2023 looked like a failure. The nature of economic cycles has long been studied, and rapid economic growth is typically followed by cooling and recession. The market bet on the Federal Reserve's monetary policy easing in 2024 amid a slowdown in the United States. However, when it became clear that their economy was more resilient to the Federal Reserve's aggressive monetary restraint, interest in the "USD" returned. As a result, hedge funds started to abandon short positions on the U.S. dollar, allowing EUR/USD to drop below 1.07.
Dynamics of the U.S. Dollar
What's next? Investors are nearly certain that the peak federal funds rate was reached in July when the Federal Reserve raised it to 5.5%. There is a slight chance of an increase to 5.75%, but what's more interesting is the rate's dynamics in 2024. In June's FOMC forecasts, a figure of 4.6% is mentioned, implying a 100 bps monetary expansion from current levels. If it rises to 5.25%, investors' appetite for the U.S. dollar will sharply increase.
The markets are predicting a decrease in the federal funds rate by roughly 75 bps next year. Such a hawkish Federal Reserve forecast would be a blow to them. U.S. Treasury yields will rise even more, and stocks will likely decline.
Market Expectations for the Fed Rate
Maintaining the previous rate assessments will damage the USD index, as investors will conclude that the Federal Reserve is concerned about a recession.
Regarding the medium-term prospects for EUR/USD, it appears that many "bearish" factors are already priced into the quotes of the major currency pair. This creates conditions for an upward correction, specially since the first signs of improvement in China's economic health have already emerged in the form of stronger industrial production and retail sales data than Bloomberg experts had anticipated.
On the other hand, a trade war between the EU and China or a new inflation peak in the United States amid rising oil prices will increase the risks of the euro falling to 1.02–1.03, and possibly even to parity.
Technically, bulls on EUR/USD are preparing for a new assault on the resistance level at 1.0715. If successful, the pair's upward movement is not guaranteed, as fair value at 1.073 is in close proximity. The pair's inability to overcome the convergence zone of 1.0715–1.0730 will be a reason for selling. Conversely, if the bulls succeed, the risks of a pullback to 1.0765 and 1.0800 will increase.
