19. A lesson on Expectation for FX_IDC:EURUSD by i_am_siew

Hi followers,
Recent events have been quite interesting. Many of you would be asking what the future holds. If you follow mainstream, you would be told that the war in Ukraine is to be blamed. People are rushing to dollar safety. Do any of you actually believe the news? Do any of you really believe the fake gurus – the ones who make you believe that they can predict everything under the sun. You name it – forex, crypto, stocks, ETF – they can predict. I hope not. If that is the case, then one thing is true. We can only rely on ourselves.

To understand the flow of currency, there are actually just two things that mattered. One is ECONOMY and the other is EXPECTATION. Between these two, the latter one is more important. If you want an example, it is easy. Even though the Fed had yet to raise any rate but the expectation that there is a rate increase in actually driving up yields and dollar. The Fed is just one of many parties out there that can create ‘expectations’. In the end, expectation is in the hand of the MARKET. The Fed can influence the market but ultimately the MARKET makes it judgement independently and act accordingly.

ECONOMY:

a) To understand the ECONOMY, we can actually look at one chart – US10Y-US02Y . You will immediately notice that it is very similar to the EUR/USD , just like twin brothers. In other words, by looking at the10s02s, you get the idea of dollar movement.

b) US10Y is the long end of the ‘curve’. If the economy is doing good and expanding, we would expect a brighter future. Then the yield rate would be high and constantly moving up. If the market thinks that the future is bad, then yield rate will move lower.

c) US02Y is the short end of the ‘curve’. It is mostly driven by short term interest rate expectation. Currently, it is moving up significantly in anticipation of rate hike.

d) In an ideal environment, US10Y is above 3% while US02Y is at a healthy low because there is no inflationary pressure. But what we actually have now is that both US10Y and US02Y are moving up in tandem. Both driven by rate hike expectation. The US10Y rise today is not because of a brighter future. And the bad news is US02Y is rising faster than US10Y .

e) if you look at 10s02s today, it is dropping fast. It is now just 0.254%. I think maybe by the end of next week or two, It will hit 0%. When that happen, you know what the future means – RECESSION.

f) the last time that happened was in 27 AUG 2019 and EUR/USD was trading at around what it is today.

EXPECTATION:

a) Modern finance will cease to function properly when the curve gets inverted. It is dysfunctional. The last time it happened in 2019, it was just briefly and soon began to rise again. Whatever it is, I think the Market expects the Fed to act accordingly. And there is one thing the Fed can do which is not to hike rates. This will bring down the US02Y , hopefully much faster than the US10Y . But the Fed is in a ‘difficult’ position because of the persistently high inflation . Anyway, the anticipated rate hike is too small to challenge the high inflation . But it is creating the conditions that can bring down the economy. Probably, their only hope now is to pray that Inflation will subside by itself. Maybe inflation is ‘transitory’ after all.

b) Previously, I mentioned that back in early Dec 2021, the EURODOLLAR futures curve got inverted. That was a message from the market that says money conditions are getting tighter, economic growth is slowing, inflation will not last, and a potential recession is on the horizon. For nearly two months after that, EURUSD seems to have stop falling and actually going to rise until Ukraine comes into the picture. Fast forward to today. That inversion got more serious. It got deeper and wider.

c) So now we have it, the Fed say they will hike rates because inflation is rising and the economy is hot. The Market on the other hand says that inflation will not last and the economy is actually slowing down. And the market is proving its point by driving down the EURODOLLAR futures curve and the 10s02s. They say don’t fight the Fed. Now lets see if the Fed is mightier than the Market. For me, I stand with the MARKET.

d) There is talk about the potential of Stagflation/Deflation. When long term growth is minimal or near zero, there is a chance that rates can be negative just so the yield curve is positive. There are some major economies doing this right now. If inflation is dollar positive, then deflation can be the opposite.

So now we wait until it hits 0%. When that happens, It will surely get the Feds attention/action. I think the choice is very clear.

a) accept high prices as what it is today but with an economy that still floats, or

b) fight inflation now with insufficiently small rate hikes. Just that there is a possibility it can bring down the economy. You can end up with high inflation plus a broken economy.

Now you have it. A simple understanding of what drives the EUR/USD . You know who the decision makers are and their standpoint.

For those interested in EUR/USD coming direction, you will need to look into the flow of speculative interest. It seems the MARKET is giving us an indication of what to expect.
https://www.investing.com/economic-calen…

P/S: As always, do not just believe what I say. Use your common sense.