Since mid-April, the dollar has been losing value at a staggering rate, which is linked to investors' expectations of future interest rate cuts in the United States. The rapid depreciation of the dollar has caught the attention of financial markets and analysts alike. This trend is primarily driven by the anticipation that the Federal Reserve will lower interest rates in response to the slowing inflation rate. As a result, investors are adjusting their positions, leading to a significant sell-off of the dollar.
However, this reaction might be premature and overly emotional, as the underlying economic fundamentals of the US remain relatively strong. Analysts are increasingly skeptical about the sustainability of this sell-off, suggesting that markets are once again driven purely by emotions and may be headed for significant disappointment if the anticipated rate cuts do not materialize as expected.
Last week brought crucial information for the currency market, causing a sudden crash of the US dollar and an unexpected strengthening of the euro. This shift was influenced by a series of key economic reports and statements from central banks. One of the main factors was the release of data indicating a decline in the rate of increase in the prices of goods and services (commonly referred to as inflation) in the US.
This data supported the narrative that the Federal Reserve might soon reduce interest rates, a move eagerly anticipated by investors. Consequently, the euro gained strength as market participants recalibrated their expectations. The volatility in the currency markets highlighted the sensitivity of exchange rates to economic indicators and central bank communications.
The rate of increase in the prices of goods and services in the US, commonly referred to as inflation, is declining again, opening the door to the interest rate cuts desired by investors. This trend of decreasing inflation is a critical factor influencing monetary policy decisions. Lower inflation rates reduce the pressure on the Federal Reserve to maintain high interest rates, thereby increasing the likelihood of rate cuts.
Investors, who are closely monitoring inflation trends, are adjusting their strategies in anticipation of these potential changes. However, the Federal Reserve has emphasized that any decision to cut rates will be based on solid evidence that inflation is under control and that the economic recovery is sustainable.
The first of these interest rate cuts is priced with a 49% probability for September this year, but experts are not certain about it. While the market has partially factored in a rate cut for September, there remains significant uncertainty. Economic data released in the coming months will play a crucial role in shaping the Federal Reserve's decision. Factors such as employment figures, consumer spending, and global economic conditions will be closely watched. Experts caution that while the probability of a rate cut is notable, it is far from guaranteed, and any unexpected economic developments could alter the Fed's course of action.
The problem is that the US Federal Reserve emphasizes the need to be sure that inflation in the US has been definitively defeated, and each reading can change the market outlook by 180 degrees. The Fed's cautious stance reflects its commitment to long-term economic stability. While the decline in inflation is a positive sign, the Federal Reserve requires consistent and sustained evidence of this trend before committing to rate cuts. Each new piece of economic data has the potential to significantly impact market sentiment and the Fed's policy direction. This underscores the volatility and unpredictability of the current economic environment, where even minor changes in inflation data can lead to substantial market reactions.
The fundamentals of the US dollar's valuation remain stable, which is why the observed sell-off seems temporary to us. The US economy, characterized by strong labor markets, robust consumer spending, and resilient economic growth, continues to provide a solid foundation for the dollar. This stability suggests that the recent sell-off may be more of a market overreaction than a reflection of underlying economic weakness.
Just one inflation reading above expectations is enough for the dollar to gain value again, so we expect the EUR/USD rate to fall to around 1.03 by the end of the year. We don't know when this will happen. We only see how much the market believes in its narrative of overcoming inflation and necessary interest rate cuts this year. This belief is driving current market behavior, but any deviation from expected inflation trends could quickly reverse these dynamics.
According to analysts, the US economy will surprise with its strength several more times, and a second wave of inflation seems quite a probable scenario. The resilience of the US economy is a critical factor in the currency markets. Analysts predict that despite current trends,the US economy has the potential to exceed expectations, driven by strong economic indicators and consumer confidence. However, this strength also carries the risk of reigniting inflationary pressures, leading to what some term a second wave of inflation. This scenario would complicate the Federal Reserve's policy decisions and could lead to renewed volatility in the currency markets.
Regarding interest rate cuts, we expect only two from the Federal Reserve and three from the ECB, but overall monetary policy should be essentially neutral. Despite the market's anticipation of multiple rate cuts, analysts forecast a more moderate approach from the Federal Reserve, with possibly only two cuts. Similarly, the European Central Bank (ECB) is expected to implement three rate cuts. These adjustments are anticipated to be measured and gradual, aimed at maintaining a balanced approach to economic growth and inflation control.
The overall stance of monetary policy is expected to remain neutral, focusing on stabilizing the economy without overstimulating it. The further upward potential of the EUR/USD valuation remains very limited since the market has already priced in almost all positive information. We still believe that in the long term, fundamentals will determine the dollar's value, and the fair value for EUR/USD is closer to parity. This perspective emphasizes the importance of economic fundamentals over short-term market movements.
However, analysts noted that they would update their view on EUR/USD if there is stronger global growth in the eurozone or if the US economy significantly slows down. This flexible approach allows for adjustments based on evolving economic conditions. For now, however, nothing indicates this, and the EUR/USD rate is slowly approaching the resistance zone around 1.09, where the direction for the coming weeks may be decided. The current market conditions suggest a relatively stable outlook for the EUR/USD rate, but this could change with new economic data.
The latest CPI inflation reading does not guarantee that the disinflation process will continue smoothly and without complications. The Consumer Price Index (CPI) is a critical measure of inflation, and its recent readings indicate a decline. However, this does not ensure a seamless disinflation process. Various factors, including supply chain disruptions, geopolitical events, and changes in consumer behavior, could complicate the path to stable inflation.
It will take some more time (possibly a quarter or a bit longer) for the Fed to be certain that it's time to ease monetary conditions. The Federal Reserve's cautious approach reflects the complexity of managing economic recovery and inflation control. It highlights the need for sustained positive trends before any significant policy shifts are made.
20.05.2024
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