Will the US economy withstand such pressure? The futures market is pricing in a federal funds rate hike of at least 75 basis points, and investors can’t help but ask this question. The spread between 10-year and 2-year Treasury yields is rapidly narrowing, approaching an inversion—a classic precursor to a recession. The famous “dollar smile theory” is coming into play: the US currency strengthens when the economy is doing exceptionally well, and when everything is catastrophically bad. It is precisely the fear of an impending downturn that is currently accelerating the EURUSD sell-off.
Historically, it has taken an average of 15 months from a yield curve inversion to the onset of a recession. The longest lag was three years, while the shortest was just five months. There have been instances where a recession was successfully avoided (such as in 1998 and 2022), which is why a popular joke emerged on Wall Street: “The yield curve has successfully predicted nine of the last five recessions.”
Looking at the phenomenally strong labor market, colossal investments in artificial intelligence, productivity growth, and the wealth effect, it is hard to believe that the US economy is about to fall off a cliff. Nevertheless, the market is pricing in Fed monetary tightening at a faster pace than current GDP growth. For now, this imbalance favors EURUSD bears. However, if US macroeconomic data suddenly starts to falter, the risks of a corrective bounce in the major pair will sharply increase.
The foundation for the current EURUSD decline is the massive divergence in the pace of monetary tightening. Futures are pricing in a 73% probability of a Fed rate hike at the upcoming FOMC meeting, while the chances of an ECB deposit rate hike stand at a mere 31%. The latter figure plummeted following cautious remarks by Christine Lagarde. The ECB President urged balancing the risks of inflation against economic cooling, noting that she does not yet see a sustained pass-through of high energy prices into core inflation.
The European central bank is treading carefully, largely due to mounting political risks in the region. Against this backdrop, FOMC officials are speaking almost unanimously about the need for an unwavering continuation of the tightening cycle. This stark contrast in central bank rhetoric is directly reflected in EURUSD pricing.
The situation is further exacerbated by a paradoxical rally in Brent crude. On the surface, traffic through the Strait of Hormuz is recovering, Saudi Arabia is expanding the capacity of its East-West pipeline, and supply is increasing, yet oil prices are still surging. Is the market pricing in a new escalation? With Iran under a strict blockade, it may have no choice but to resume hostilities. Surging crude prices act as a direct boost to inflation and provide an ironclad justification for aggressive Fed action.
Price targets of 1.13 and 1.12 for short EURUSD positions remain intact. The bearish strategy remains highly relevant.
