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Expectations and Reality. At the end of 2022, the market consensus was that the U.S. economy would face a downturn by the end of 2023, dragging the entire world into a recession. In reality, the U.S. GDP expanded by 3.3%. Currently, investors are confident in a soft landing, but financial conditions are so stimulative that, in fact, gross domestic product could accelerate, and benign inflation could turn malignant. Dealing with it will require a new cycle of tightening monetary policy. Excellent news for EUR/USD bears.
At present, one thing is clear: the existing interest rate level does not constrain economic activity. Financial conditions are to blame for this. Expectations of a softening of the Federal Reserve's monetary policy led to them being dressed up to levels seen in the summer. Stock indices added about 15%, Treasury yields fell, the U.S. dollar seriously weakened in the fourth quarter. Add to this the fall in oil and gasoline prices, allowing Americans to save, and the increase in real wages against slowing inflation. This increases their spending.
Dynamics of Financial Conditions and Oil Prices
On such a backdrop, what should GDP do? Grow! No landing is visible on the horizon. Neither soft nor hard. The economy is strong and can be even stronger. And in such conditions, there is a great risk of inflation accelerating. The Fed will want to take a pause to understand what is happening with consumer prices, and most likely, this pause will extend until March. That's why the U.S. dollar is rising! Investors expected a softening of monetary policy in the spring, but it's not visible.
Certainly, everything can change if the U.S. labor market suddenly begins to freeze. The revision of data towards a decrease has long been known, but if non-farm payrolls seriously disappoint in January, unemployment rises, and average wages slow down, the Fed will have grounds to cut the federal funds rate in March. However, such a scenario is associated with a soft landing and represents the opinion of the majority. Which, as we remember, has been wrong more than once.
A much more likely scenario is one in which the Fed begins a cycle of monetary expansion in June and takes three steps along this path, as it predicted, not six, as the market expects. If so, then EUR/USD has good chances not only to fall to 1.07 but also to 1.05. The pair rose on excessive optimism about a massive cut in the federal funds rate. Why not return to the original positions once the bulls realize their mistake?
Technically, the rebound of EUR/USD from moving averages, as expected, became a catalyst for the development of a pullback. At the same time, a cluster of pivot levels is near the 1.08 mark, increasing the likelihood of an upward bounce. A failed assault is a reason to lock in profits on shorts and switch to longs. On the contrary, in case of a breakthrough, we continue selling.
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