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Inaction can sometimes be an action, as aptly expressed by Christine Lagarde when explaining the ECB's reluctance to raise rates in October. The Fed will find plenty of reasons to justify another pause in the cycle of monetary policy tightening. This includes progress in combating inflation, rising Treasury yields, which do the central bank's job for it, and uncertainty due to the conflict in the Middle East. However, what if the Federal Reserve prematurely deemed its mission accomplished? Its mistake will be costly for EUR/USD bulls.
In reality, no one knows the time lag for monetary restriction. It affects the economy by tightening financial conditions, and their peak was reached in December, long before the Fed stopped raising the federal funds rate. Perhaps all the worst for the United States ended in the first and second quarters, and in the third, GDP shot up by 4.9% as the economy adapted to high borrowing costs.
Dynamics of financial conditions and the global stock market
The mantra of FOMC officials that the rally in Treasury yields is doing the central bank's job makes sense, but the underlying reason is crucial. What is at its core? The strength of the economy? Massive Treasury issuances? Or perhaps the markets' recognition that the federal funds rate has not yet reached the level that would restrain GDP growth? History shows that at the end of the monetary tightening cycle, the yield on 10-year bonds was higher than the Fed's rate. And both have room to grow?
If that's the case, investors are clearly underestimating the U.S. dollar. Lately, EUR/USD bears have not responded to good news for themselves, and bad news for the euro unexpectedly led to an increase in the pair. As a result, there is a feeling that the USD index has reached its peak. Barclays, Morgan Stanley, and NAB advise selling it, but their opinion can change at any moment.
Dynamics of bond yields and Fed rates
Furthermore, the U.S. dollar has the important advantage of the crisis in the Middle East. As much as investors would like to see de-escalation in the armed conflict, the fighting continues, and soldiers are dying. The closer a certain region is to war, the worse it is for its economy. While Europe suffered from an energy crisis due to events in Ukraine in 2022, the United States benefited as a net exporter of energy products.
The same may happen in 2023-2024. Involving other countries in the Middle East conflict will immediately impact the cost of oil and gas. Supplies from Qatar and other countries to the EU will be threatened, which will negatively affect the eurozone's economy.
Technically, on the daily chart, EUR/USD did indeed complete a reversal pattern 1-2-3. The "sell on rally" strategy, with subsequent resistance at 1.0645, proved to be successful. We continue to add to short positions as the main currency pair moves down. Initial target levels are 1.050 and 1.041.
*The market analysis posted here is meant to increase your awareness, but not to give instructions to make a trade.
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