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EUR/USD breaks out as Fed turns marginally less hawkish relative to ECB

As we pointed out repeatedly last week, the dollar was always going to struggle in the event of a positive outcome in US-China trade talks at the G20 meetings in Argentina. And so it has proved thus far in the week, with the greenback falling against all her major rivals. Even the beleaguered British pound is now positive on the week. The rationale for our bearish dollar view was that by showing willingness to sort out their differences, the US was likely lower its import tariffs on goods arriving from China if and when they reach a trade deal – which is now expected in the months ahead. This in turn would lower import costs for US producers and consumers, thereby easing the pressure on inflation and, by extension, interest rates. In fact, the Federal Reserve has already indicated that it is not as hawkish as it once was, judging by recent comments from a few members, including the Chairman himself. Jerome Powell last week insisted that interest rates were now just below neutral, indicating that the FOMC may pause hiking earlier than previously expected. The Fed’s reassessment came amid growing signs that global demand was hit by falling exports to some emerging markets, owing in part to the recent turmoil in EM currencies. The fact that oil prices have plunged at the same time has further dampened inflationary pressures.

ECB needs to normalise if ammunition needed to combat potential downturn in economy

Consequently, the major central banks are now in no rush to normalise their respective policies, although the likes of the European Central Bank feel the need to do so now in the event more ammunition is needed to combat a downturn in the economy at some point down the line since monetary policy here is still extraordinary loose. The ECB’s asset purchases programme is finally going to end this month, although it is not clear when interest rates will actually go up. The central bank has insisted on a number of occasions that it will be after the summer of 2019. With the ECB’s policy normalising plans still unchanged while the Fed is apparently no longer as hawkish as it once was, and assuming the markets are efficient at discounting changes in interest rate expectations, then the EUR/USD ‘should’ in theory go up from here.

German-US 10-year bond yield spread narrows

The above divergence is actually represented graphically in our featured chart below. Here we have a daily chart of the EUR/USD against the German-US 10-year bond yield spread. As can be seen, there is a bit of divergence forming: the EUR/USD is still making lower highs while the yield spread has made a higher high in the favour of German bond yields. Thus, if fixed income is the "smart money," then this chart suggests that the EUR/USD exchange rate ‘should’ go higher. Note that the previous divergences correctly predicted EUR/USD’s directions.

EUR/USD creates bullish technical pattern

In fact, the exchange rate may have already bottomed out last month when price fell briefly below long-term support around the 1.13 handle (see the monthly EUR/USD chart in the inset). However, the bulls have managed to reclaim this important technical level and judging by the shape of the monthly candlestick pattern that has been left behind on the monthly chart – i.e. a doji – the directional bias is now bullish again. Indeed, on the lower time frames, this week’s price action has been bullish - suggesting that there has been some follow-through in buying momentum. The daily chart (not included here) shows that the EUR/USD is now trying to erode its bearish trend line after breaking several short-term resistance levels including most recently 1.1380.


Source: TradingView and FOREX.com.

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