Dovish Fed Hike To Support EUR/USD Bulls

EUR/USD trading idea by
Trading strategy: Long  
Open: 1.1320
Take profit: 1.1500  
Stop-loss: 1.1230
Recommended size: 1.67 mini lots per $10,000 in your account

EUR/USD is making recovery attempts from Friday's 1.1270 low, but is likely to run into solid resistance. A break and daily close above the 30-day moving average, which is now at 1.1354, will shift the overall bias back to the upside. In our opinion dovish Fed hike will support the EUR/USD bulls this week. We remain long.

This week, the Federal Reserve will end its eighth and final regular FOMC meeting of the year. It is widely expected that the committee will raise the target range for the federal funds rate by another 25bp to 2.25-2.50%. This would be the fourth rate hike this year, and the total increase of 100bp is the largest annual rise in the short-term interest rate since 2006. At the same time, the interest on excess reserves, IOER, will likely be raised by only 20bp. The goal of this technical adjustment is to bring the effective fed funds target rate back to the middle of the target band. The same tweak was used in June.

Fed rate and U.S. inflation

More important than the actual rate hike is the outlook for the coming years. The updated Summary of Economic Projections is likely to show very similar economic forecasts as in September. These include GDP growth gradually slowing from around 3% in 2018 to 2.5% in 2019 and towards potential growth of 1.8% in 2021. The jobless rate is likely seen as hovering between 3.5% and 3.75% throughout the forecast horizon, while inflation rates remain close but slightly above the 2% target. Moreover, the post-meeting statement should reiterate that “risks to the economic outlook appear roughly balanced”.

We also expect the statement to reiterate that “further gradual increases in the target range for the federal funds rate will be consistent with sustained expansions of economic activity, strong labor market conditions, and inflation near the Committee’s symmetric 2% objective over the medium term.” The FOMC members’ interest rate projections (the “dots”), however, are likely to reveal that the pace of these gradual hikes is slower than the committee previously thought. In particular, we expect the dots to show only two hikes for 2019 (down from three), which brings the Fed’s median view in line with our forecast. What happens to the forecasts for 2020 and 2021 critically depends on changes to the longer-run neutral forecast of the fed funds rate. Following recent remarks by senior FOMC members, notably Fed Chair Jerome Powell at the Economic Club of New York, we think it is most likely (though not a foregone conclusion) that the median estimate for the longer-run fed funds rate will come down from 3% to 2.9% or even to 2.75%. If that is correct, the dots for 2020 and 2021 will each come down by 25bp as well, which essentially lowers the entire “dots-curve” by one rate hike. If the estimate for the longer-run rate remains unchanged, the dot for year-end 2021 will remain unchanged, but it would take the FOMC a bit longer to get there, with the hikes being more gradual, rather than occurring in 2019 and 2020.

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Disclosure: Long EUR/USD.

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