Stock markets have taken a step back from recent highs, and the currency market is seeing some strengthening of the dollar ahead of the Fed meeting later Wednesday. Interestingly, EURUSD has been predominantly declining for the last three weeks but found support near the 50-day moving average around 1.2100 so far this week. Additionally, there is a 73.4% Fibonacci retracement of the rally from April to the highs of May near this level. Thus, the bulls are in no hurry to give up this defensive line, intending to stay within the upward trend in the pair.
Therefore, the recent pullback might be a step back to recharge the bulls’ strength before hitting new highs. This has been our central scenario for a long time, but its relevance has diminished considering the new fundamentals.
Earlier this year, EURUSD came under pressure due to the ever-increasing difference in growth rates between the US and Eurozone due to the scale of vaccination and support packages that were higher in the US.
Last week the ECB provided the euro with another reason to lag, announcing that it was too early to discuss winding down support and that the current programmes will be executed at a higher pace in the summer, which was picked up in the second quarter.
Today’s relevant question is what stance the Fed is taking, which is the main reason why markets are nervous. The inflation rate and the extent of free liquidity in the US financial system are at levels where the Fed is expected to tighten policy. Or at least a tapering of easing programmes.
Suppose the Fed acts solely within the mandate of price and financial stability by signalling the start of discussions to roll back QE. In that case, it will bring buyers back into the dollar and promises to trigger an upward trend of up to half a year, as it has done on average in history at such turning points. This could kick-start a market correction, taking more than 10% off the market, returning the Dollar Index to 93–95, EURUSD to 1.1500–1.1700 and GBPUSD to 1.3100–1.3500 in the coming months.
On the other hand, both inflation and excess liquidity can easily be explained by temporary logistical congestion in goods or service constraints. Meanwhile, overall, employment is far from full, which the Fed could draw attention to later today by referring to the fact that the central bank in the USA also has the mandate to maintain full employment.
If the Fed sticks to the same line as the ECB earlier, new upward momentum could await the stock markets. After a prolonged consolidation and a minor correction, it could prove to be particularly strong. The USD could lose the support it has steadily received near current levels on the currency market under these circumstances.
For the USD index, this line passes near 90, in EURUSD near 1.2250 and GBPUSD near 1.4200. A break above opens new uncharted territory with entry levels we have not seen in recent years. A new round of dollar retreat could bring back more substantial gains in commodity markets, as well as bringing buyers back into high yielding currencies, reviving carry-trade.