Something is clearly going wrong. Central banks, facing stubbornly high inflation, are tearing their hair out. Their year-long efforts to contain price growth are falling short. As a result, the central banks of Australia and Canada are resuming cycles of monetary tightening. Meanwhile, the Federal Reserve's pause weakens the US dollar. But not for long. The market currently does not believe in a 50 basis point increase in the federal funds rate in 2023, but it will have to.
In theory, cycles of monetary tightening should cool down the economy and help inflation return to the 2% target. In practice, labor markets remain surprisingly hot, price declines are sluggish, and the US economy looks robust. In contrast, the eurozone slipped into a technical recession in the 2022-2023 period. The reasons for the resilience of the US GDP to the most aggressive rate-hiking cycle can be found in massive fiscal stimuli and supply disruptions due to the COVID-19 pandemic. These factors have forced employers to hold onto their employees by their teeth.
The currency bloc suffered from the armed conflict in Ukraine and the associated energy crisis, but the transmission of monetary policy to the economy in Europe is happening faster than in the US. Perhaps Allianz Global Investors is right in claiming that the Fed's rate hikes have not had any effect yet. But it will impact the economy and financial markets, without a doubt.
In any case, the Fed considers its job unfinished and projects two more increases in borrowing costs at the FOMC meetings in 2023, bringing it to 5.6%. The central bank is not satisfied with the dynamics of financial conditions. Therefore, we can expect a hawkish rhetoric from Fed Chair Jerome Powell in his speeches before the US House of Representatives and the Senate.
Dynamics of financial conditions in the USIn Europe, the situation is somewhat different. With a less flexible labor market compared to the US, the eurozone can expect a quicker cooling down of the labor market, as well as the overall economy. While underlying inflation remains at elevated levels, it will start to decrease in the coming months. This gives Nordea reason to believe that markets are overestimating the determination of the ECB. In reality, the cycle of monetary tightening in the eurozone will end in July with the deposit rate at 3.75%. Once the markets realize this, they will push EUR/USD down to 1.07 during the summer. Overall, Nordea expects the main currency pair to trade in the range of 1.06-1.1 in 2023. In 2024, it will go higher.
For now, the focus is on Powell's rate-related congressional testimony, as investors have shown faith in the reactions to the outcomes of the June meetings of the Fed and the ECB. Therefore, the rhetoric of the Fed chair will certainly have an impact on EUR/USD.
Technically, on the daily chart, the main currency pair is experiencing a rebound from a doji bar. This allows us to stick to our previous strategy. We are building up short positions on EUR/USD formed from the range of 1.0965-1.0975 on breakouts of support levels at 1.091 and 1.0895.