19.05.202116:26 Forex Analysis & Reviews: EUR/USD: dollar retains room for maneuver, while euro's rally may be short-lived

The greenback stabilized against its main competitors on Wednesday ahead of the publication of the FOMC meeting minutes from April.

Falling US stock indices and recovery in Treasury yields support the US currency.

Investors have faced a number of questions lately, namely whether the rise in prices in the United States will be temporary or more sustainable, and whether the Fed will raise interest rates earlier than expected.

The US stock market ended yesterday's trading in the red for the second day in a row.

The country's finance minister Janet Yellen said yesterday that the White House intends to raise taxes for corporations and wealthy Americans as part of the infrastructure spending plan proposed by US President Joe Biden.

Meanwhile, inflation risks continue to be the main pressuring factor for shares. Investors fear that due to accelerating inflation the US regulator will have to cut back on its asset repurchase program earlier than planned.

Market participants are also concerned about a possible further increase in the yields of US Treasury bonds, which will cause an outflow of funds from risk assets to the government debt market.

Federal Reserve officials continue to argue that the surge in inflation is temporary, and the regulator is not going to tighten monetary policy in the near future.

Most investors take these words at face value. However, some of them still question the temporary nature of inflation.

The pressure on prices could increase sharply if the trend that emerged last week will persist over the next few months. This could push the Fed to tighten its monetary policy ahead of schedule.

Even if the regulator allows inflation to temporarily exceed the 2% target to stabilize at the average level, the Fed may need to take earlier steps, especially as the trend towards increased price pressure will remain stable.

So, the next few months will be critical for understanding the prospects of inflation and its possible implications for the Fed's monetary policy tightening.

The regulator has not yet given specific figures either on the scale of inflation or on the time its acceleration may last. This data could serve as a basis for a change in the monetary policy. Thus, the US central bank is apparently trying to preserve room for maneuver.

The Fed's dovish monetary policy combined with increased inflation is putting pressure on real yields which is a negative moment for the US dollar.

After hitting the lowest levels since early January, the US dollar index was able to recover ahead of the release of the FOMC minutes from April meeting that is due on Wednesday evening.

It is widely expected that the document will reflect the Fed's intention to leave its monetary policy unchanged which will be another factor in favor of opening short positions on the US dollar.

"Minutes from the April FOMC meeting are likely to confirm recent statements by Fed Deputy Chairman Richard Clarida who pointed to the need for further monetary stimulus," analysts at the Commonwealth Bank of Australia said.

However, the Fed officials can make unexpected statements and express fears over accelerating inflation which will provoke increased volatility in the market and partial closure of short positions on USD.

Many experts agree that the US dollar will continue to decline in the short term as the Fed will adhere to a dovish monetary policy, downplaying the fact of rising inflation.

However, the US Treasury market is unlikely to withstand higher inflation for a long time.

"It all looks pretty straightforward for USD bears at the moment, with wind at the back in terms of Fed expectations (the Fed priced near the lows of the cycle in terms of the lift-off timing for their first rate hike despite the extremely hot April CPI print of last week and rising breakevens that are driving US real yields back to the recent lows), but we continue to keep a nervous eye on the longer end of the US yield curve – any new volatility there combined with the positive correlation we have noted recently in US treasury and equity prices could suddenly turn the tables on the situation," strategists at Saxo Bank reported.

According to experts, the main risk for investors is that they may underestimate the likelihood of higher inflation and higher interest rates.

So far, there is a growing consensus that the Fed will allow what it sees as a temporary acceleration in inflation. This will keep the US dollar at a lower level against most major currencies.

"The fact that the Fed is showing no signs of tightening its policy is virtually nullifying the greenback's gains from last week following stronger-than-expected US inflation data," MUFG analysts said.

At the moment, only the head of the Federal Reserve Bank of Dallas, Robert Kaplan, is in favor of raising interest rates as early as 2022.

If the minutes from the last FOMC meeting show that R. Kaplan has supporters, the US dollar will have opportunities for growth. Otherwise, the American currency is at risk of a deeper fall.

The greenback managed to attract buyers in the area of 89.68–89.70. If the pullback continues, the USDX may target the level of 89.20 (current yearly lows).

The index will remain bearish as long as it trades below the 200-day moving average which is now moving around 91.80.

"The trade-weighted dollar rate is located at an important technical level - the lower end of the range that has prevailed since 2015. A further decline is highly likely. We expect the EUR/USD pair to reach 1.2500 in the summer," analysts at Deutsche Bank said.

According to the MUFG, the outlook for the single European currency is favorable, especially amid improvements in the European economy.

"The EU intends to reach its vaccination target of 70% in adults by mid-July. As the incidence of COVID-19 declines, national governments are poised to lift restrictions. This will contribute to faster economic growth in the region," the bank's experts noted.

"Financial conditions in the eurozone remain accommodative despite recent gains in yields and the euro. This could prompt the ECB to wind down its QE program in the third quarter. The next meeting of the ECB, which will be held on June 10, will shed light on the future plans of the regulator. The decision to slow down the pace of asset purchases will support the euro," they added.

On Wednesday, the EUR/USD pair renewed its multi-month highs, rising to 1.2245, but later it pulled back slightly.

Alertness ahead of the release of the Fed minutes from April and the desire to take profit at the current highs serve as the main driving forces in the markets.

Rising Treasury yields and weakening risk appetite helped the US dollar recover across the board.

In the minutes from the last Fed meeting, investors will look for hints of the regulator's intention to adhere to a soft monetary policy in the future, which may return interest in risk assets and put downward pressure on the US currency.

Credit Agricole believes that the growth of EUR/USD will be short-lived.

"By June 10, the recent tightening of financial conditions in the eurozone could shift the balance of risks towards postponing the reduction of PEPP to the third quarter, especially as the ECB's Governing Council is trying to avoid a further surge in European government bond yields during the period of relatively low liquidity in the summer," the bank strategists said.

"At the same time, improved data on economic growth and inflation in the US could push Treasury yields to highs last seen in March. As a result, the long-term yield spread of European and US government bonds will again become more negative and put pressure on EUR/USD," experts added.

So far, the main currency pair remains bullish.

Important resistance for EUR/USD is found at 1.2245 (recent high) which almost perfectly coincides with 1.2243 (February high and a double top). The next important levels are located at 1.2280 and 1.2350.

The support levels are located at 1.2200, 1.2180, 1.2150, and 1.2100.