26.12.202400:28 Forex Analysis & Reviews: The Dollar Skims the Cream

Markets are celebrating Christmas, and the EUR/USD pair is set to close the year on a mixed note. On one hand, the euro could benefit from the so-called "Santa Claus rally" in U.S. equities. Historically, the last five trading days of the outgoing year and the first two days of the new year have led to an average gain of 1.3% in the S&P 500 since 1950, compared to an average gain of 0.3% during other seven-day periods. If the Santa Claus rally occurs, the market typically rises by 1.4% in January and 10.4% over the following 12 months. This is generally bad news for a safe-haven asset like the dollar. However, the dollar remains unaffected.

Despite the S&P 500's strong growth the day before Christmas, there are reasons to believe that this year's Santa Claus rally may not materialize or may fail to support EUR/USD. When the Federal Reserve signals a pause in its monetary easing cycle, risk assets often face pressure. It is uncertain whether December's rate cut was the Fed's final move in this cycle.

If the Fed has indeed concluded its monetary expansion, the yield on 10-year Treasury bonds is likely to rise back above 5%. U.S. debt now offers Japanese investors a return for the first time since 2022, even after accounting for currency hedging. Many hedge funds and asset managers are forgoing currency hedges, betting on an upward trend for USD/JPY. This capital shift from Asia to North America strongly supports the U.S. dollar.

Dynamics of Japanese and U.S. Bond Yields

The appeal of U.S. assets is growing significantly, which means that if a Santa Claus rally occurs in U.S. stocks, it is unlikely to benefit EUR/USD bulls. When the S&P 500 surges while European stock indices decline due to potential tariffs from Donald Trump, capital flows from Europe to the U.S., putting pressure on the euro and strengthening the dollar.

Capital flows are not the only factor contributing to the downward trend of EUR/USD. Futures markets are predicting a 33-basis-point cut in the federal funds rate by 2025, indicating only one potential instance of monetary easing, with less than a 50% chance of a second cut. In contrast, derivatives markets expect the European Central Bank to lower its deposit rate by 100 basis points. This widening gap in borrowing costs between the U.S. and Europe is likely to continue driving the EUR/USD downward.

Dynamics of the ECB Rate and Forecasts

The contrasting rates of monetary easing, differences in economic growth, and capital flows from Europe to the U.S. are fundamental reasons behind the bearish trend of the euro against the U.S. dollar.

Technically, on the daily EUR/USD chart, sellers are trying to reestablish the downtrend. To do so, they need to push the pair below the local low of 1.034. It appears to be only a matter of time before this happens, so it is wise to stick to a selling strategy.