When the opponent is defeated, the time of euphoria comes. But who knows, perhaps they will rise again? The rise in unemployment to 3.8%, a slowdown in employment, and average wages have allowed investors to talk about the Federal Reserve's imminent victory over inflation. Stock indices reacted positively to the labor market report for August, and Treasury bonds were sold off. "Bears" on EUR/USD received preferences due to American exceptionalism. But who said that inflation has thrown in the towel?
The easiest period of combating the highest prices in decades is behind us. When central banks, led by the Fed, began tightening monetary policy, economies were growing above trend, and labor markets seemed like a monolith. Now that the stone has begun to crack, and discouraging business activity data indicates serious problems, this calls for new approaches in the fight against inflation. Resolve gives way to caution. However, no one is in a hurry to lower interest rates. And that's where the hidden potential of the U.S. dollar lies.
Indeed, derivatives indicate that by the end of 2024, the federal funds rate will be at 4.5% with a 68% probability. The chances of it dropping to 4.25% are 42%. In other words, the futures market is factoring in risks of borrowing costs decreasing by 100-125 basis points. However, the actual outcome is likely to be different.
One of the reasons for the sharp slowdown in inflation is the fall in energy and other commodity prices. But recently, the commodity index led by oil has started to rise. This increases the likelihood of a new spike in consumer prices. That's why the Fed is not rushing to claim the mission is accomplished and is keeping all options open.
Dynamics of inflation and the commodity index
The Federal Reserve is in a more advantageous position than the markets. The central bank can afford to wait and see the incoming data. Investors, on the other hand, understand that they have gone too far with predictions of a 100-125 basis point rate cut in 2024. It's good if macroeconomic data in the United States deteriorates. But what if everything goes according to plan?
In a strong economy, there cannot be weak inflation. Pent-up demand, rising real incomes of Americans, and a robust labor market suggest that a new wave of PCE growth is coming. And then everyone will remember the Federal Reserve and the strong dollar. Its potential may be far from exhausted. The chances of the Fed's "dovish" pivot next year are too overestimated.
Dynamics of market expectations and Fed rates
Of course, the euro may occasionally counterattack. But it will all resemble the jumps of a dead cat. Until Eurozone statistics consistently improve and U.S. data worsens, the EUR/USD rally towards 1.1 will not happen. Instead, the main currency pair will plummet to 1.05-1.06.
Technically, breaking support at 1.0775 threatens the continuation of the EUR/USD peak towards 1.071 and 1.066, allowing shorts to accumulate.
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