QE tapering and a federal funds rate hike are not the only ways to combat inflation. The Fed is actively withdrawing money from the market. How can that affect stock indexes and the EURUSD? Let’s check it out and make a trading plan.
Monthly fundamental forecast for the dollar
After the S&P 500‘s 47th record high close, it occurs to me more and more often that bulls are being led to the slaughterhouse. The stock index is growing when the economy is up on cyclical stocks and when it’s down. In the latter case, it’s technological giants that grow. The index rises amid inflation spikes as everyone believes that’s a peak, and amid inflation slowdowns, too. The S&P 500 goes on rallying even if the Fed’s hawks continue saying it’s time to taper QE. They say the central bank will continue moving at a snail’s pace all the same. The bubble is blowing up, so what will happen to the EURUSD once it blows out?
Investors believe in the temporary nature of high inflation and the Fed’s slow pace. They don’t doubt new fiscal relief packages will be approved as fast as the previous ones as the Democrats control Congress. Corporate profits and low borrowing rates impress the market, while such factors as overassessment and the debt ceiling are considered irrelevant and therefore neglected. There’s just one factor that favors excessive appetite for stock buying — people have too much money. Liquidity is too high, and S&P 500 bulls should start worrying as the Fed has started withdrawing money from the system.
The central bank’s reverse repo operations reached a new record high of $1.087 trillion on 12 August. The Fed uses this type of borrowing to slow down money supply growth and inflation. However, financial markets might get disturbed when M2 grows slower than GDP. At the same time, trade volumes will most likely rise, as Treasury uses cash to avoid breaching the debt ceiling.
Dynamics of reverse repo operations
Source: Bloomberg.
Inflation did slow down in July, but producer prices have been beyond Bloomberg’s expectations for the fifth consecutive month. The Fed will not hurry to normalize monetary policy, but QE withdrawal is just a matter of time. Twenty-eight out of 43 Reuters experts think the central bank will announce the beginning of their $120 billion program taper in September. More than 30% of respondents bet on November or December. Sixty percent of economists expect the bond-buying program will start shrinking in Q1, 2022. The rest answered it would happen in Q4, 2021.
The likeliest scenario is curtailing bond buying by $10 billion a month, but I think that will be faster. A drastic decrease in the budget deficit and in Treasury’s need for new borrowings will turn the Fed into a whale in the debt market pond, provoking excessive volatility.
Monthly trading plan for EURUSD
So, they continue persuading investors that the Fed will normalize its policy at a snail’s pace while the central bank continues to actively withdraw liquidity from the financial system. The S&P 500 will therefore correct sooner or later, and demand for the USD will grow. Continue selling the EURUSD on the rise with targets at 1.166 and 1.158.
Price chart of EURUSD in real time mode
The content of this article reflects the author’s opinion and does not necessarily reflect the official position of LiteForex. The material published on this page is provided for informational purposes only and should not be considered as the provision of investment advice for the purposes of Directive 2004/39/EC.
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