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Rumors of an imminent agreement on the debt ceiling and the normalization of market expectations regarding the fate of the federal funds rate have helped EUR/USD find a bottom. According to a Bloomberg insider, Republicans and Democrats have narrowed their differences and are approaching a deal. The bill could be voted on in Congress as early as Tuesday, May 30, which would enable the Treasury to pay its obligations and avoid default.
One of the achievements mentioned by the White House is a 3% increase in circulation spending. Meanwhile, Republicans are likely to achieve many of their goals regarding budget cuts. The size of the borrowing limit increase and the time frame are not disclosed, but it is likely to be around $3.5-4 trillion over a period of about two years. Positive news from the negotiation table has led to a decrease in Treasury bond yields across the curve. This has weakened the US dollar's position against major world currencies.
It is worth noting that in May, EUR/USD declined not only due to the deadlock on the debt ceiling issue. There has also been a normalization of market expectations regarding the federal funds rate. While investors were expecting it to drop to 4% by the end of the year in mid-March, and the forecast was 4.25% just three weeks ago, it has now risen to 5%. With the anticipated borrowing cost increase to 5.5% in July, this implies two acts of monetary tightening by the end of 2023.
The dynamics of market expectations regarding the federal funds rate
In reality, the changes are quite significant, but the market still believes in a dovish pivot, despite the moderately hawkish tone of the latest FOMC meeting minutes. Some officials spoke about inflation slowing down too slowly, while others noted that price pressure remains steady. It is quite possible that if the new US macro data continues to pleasantly surprise, the updated Fed forecasts for PCE will be raised.
However, there is another possible scenario. A significant cooling of the labor market in May could be the catalyst for investors to abandon the idea of a rate hike in July and increase the chances of monetary expansion in 2023. As a result, EUR/USD will begin to recover lost ground.
This time, the upward movement of the currency pair will be hindered by the deteriorating state of the leading economy in the eurozone, Germany. The IMF predicts that Germany's GDP in 2023 will demonstrate the weakest performance among G7 countries, and Chancellor Olaf Scholz's optimism appears to be artificial.
IMF GDP forecasts for G7 countries
I believe that Germany's problems are closely linked to the sluggish recovery of the Chinese economy. If China accelerates in the second half of the year, the European machine will also come to life.
Technically, after reaching the target at 1.071 on EUR/USD shorts, it bounced back up. A breakthrough of the pivot level at $1.076 will inspire bulls to strike and will also serve as a basis for forming short-term long positions on the euro towards $1.08 and $1.082. That's where we will start looking for selling opportunities.
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