Fed Signals Increasing Policy Flexibility, Euro Takes Dovish Clues from Persistent Inflation

44299 fed signals increasing policy flexibility euro takes dovish clues from persistent inflation

US equities rose, and the near end of the yield curve fell following the Fed meeting (2-year Notes 3.1% -> 2.99%), as the Fed rhetoric began to shift from high inflation to a potential economic slowdown due to policy tightening. Recall that in May and June, the comments of the Fed officials, including chair Powell, tried to convince the markets that the Fed was throwing all its efforts into fighting inflation and unfortunately, the US economy will have to pay the high price in terms of slowing growth rates. At the time, equity and dollar markets traded the idea that the Fed was tightening when the US expansion started to show its first cracks, which could potentially exacerbate a downturn. However, data on June retail sales (+1% MoM), U. Michigan inflation expectations (7.9% -> 7.6%) and US gasoline prices in July showed that a favorable mix of still decent growth rates and slowing inflation is emerging in the economy, which should, in theory, increase Fed flexibility and help the central bank to slow down a costly tightening process. The Fed’s vague forward guidance outlined yesterday and the move away from a front-loaded tightening approach in favor of a data-oriented one (the ECB did the same at the last meeting) had two important consequences: the dollar and markets in general should become more sensitive to incoming data that will pave the way for the next Fed decision, and the risks of a dovish Fed tweak at the upcoming meetings, increased.

Analyzing the probability distribution of how much the Fed rate will rise by the end of the year, it can be seen that the 100 bp outcome still has the highest probability, but the probability of a 75 bp outcome increased while the odds of a 125 bp and higher outcome decreased, signaling a dovish market interpretation of yesterday’s FOMC meeting:

Today’s release of US GDP data will be the first test of the dollar’s reaction function to incoming data. The consensus forecast is 0.5% QoQ in the second quarter, but data on firm inventories and foreign trade point to downside risks.

The release of the Durable Goods Orders report yesterday underpinned the demand for risk, as the figure was well above the forecast – growth in June was 1.9% MoM, against the forecast of -0.5%. Apparently, good dynamics were ensured by the growth of orders in the defense sector, excluding orders in this sector, the gain was 0.5% against the forecast of 0.2%. Orders for durable goods is the function of consumer expectations, as they are expensive purchases, so the better-than-expected print provided additional positive information on household expectations.

Inflation data in Germany disappointed, the report showed today that inflation slowed down from 7.6% to 7.5%, missing the forecast of 7.4%. At the same time, the price level increased by 0.9% MoM, falling short of 0.6%. Considering that the ECB at the last meeting signaled that the significance of incoming data in policy is increasing, the initial negative reaction of the EURUSD to the report is likely to gain momentum.

From a technical point of view, the potential reversal of the EURUSD after the parity test began to fade – the price, after the rebound to 1.025, fluctuates in the range of 1.02-1.01, slowly sliding down against the backdrop of negative news on inflation and growing risks of an energy crisis, especially in light of the news about declining gas flows from the Russian Federation via the Nord Stream 1. As I wrote in the previous article, the risks in this story are skewed towards further escalation, and therefore there should definitely be a bearish bias due to concerns of slowing activity on the back of lower gas consumption and likely higher inflation in the coming months. The pair is in a clear bearish trend and, as we know, without meeting resistance, the trend tends to continue. There are no resistance factors yet, so the downward movement should rather be considered as a continuation of the bearish trend:

Disclaimer: The material provided is for information purposes only and should not be considered as investment advice. The views, information, or opinions expressed in the text belong solely to the author, and not to the author’s employer, organization, committee or other group or individual or company.

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Written by Arthur Idiatulin

Arthur is a stock market and currency expert with a vast experience in market research and investment consulting. Dedicated Forex trader and financial practitioner, keen on testing new trading techniques and investment strategies.


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