How Short rates affect EURUSD

This excerpt is part of a larger blog post where I'll delve into my 2024 trading strategy and explain the rationale behind my trades.

For those new to trading, early career decisions play a pivotal role in shaping one's trading trajectory, significantly impacting both profitability and mental ability to continue trading over the years. The two choices are clear:

1. Follow trade signals devoid of explanations, endorsed by traders concealing their identity, background and their P&L data. These traders may excel at marketing on social channels but might be grappling with substantial losses or in most cases lack proof of making consistent profitable trades in their short careers. They often will have conflict of interest arrangements with brokers, encouraging frequent trading leading to unnecessary losses.

OR

2. Grasp the art of consistently making trades by understanding fundamental drivers. This involves being discerning about trades based on volatility parameters that have a higher probability of profit.

If option 1 resonates with you, then it's time to redirect your attention to the myriad of 'Educators' who, despite lacking real trading experience, are eager to part you from your hard-earned cash. Always demand a verified P&L link (not screen shots) and observe their response.

For those opting for option 2, this marks the commencement of a series of blog posts interpreting endogenous and exogenous factors that influence forex pairs and how to capitalize on them.

Background.
When I formulate a trade idea, my first task is to gauge the purchasing power of a currency. This involves analyzing an extensive set of historical indicators like PMIs, NMIs, CC, building permits, etc. The resulting scorecard, based on historical values, aids in determining whether a currency is gaining or losing purchasing power.

Comparing this exercise across other G10FX currencies provides the foundation for my trade. I can identify which currency has a short bias, which has a long bias, and the specific pair I am confident in shorting or going long. All this occurs before delving into volatility parameters (which we'll explore in a future post). When a future data is released, the movement in the pair is either confirming or contradicting the trade idea, the trade idea is still valid but maybe it doesn't have as much margin of safety as first thought.

In this blog, I'll delve into one key statistical driver— the short-term interest rate differentials. While crucial, it's not the sole determinant of EURUSD movement.

Last month, Jay Powell's Fed hinted at considering three rate cuts in 2024. This decision stems from the U.S. economy's accelerated path to disinflation. Powell, having waited for inflation since 2018 and taking no action in 2021 & 2022, aims to prevent the economy from slipping into deflation. Simply put, disinflation benefits equities and the economy, but deflation is detrimental to jobs and the stock market.

Meanwhile, the ECB has adopted a cautious "wait and see" approach, despite its economy teetering on the brink of deflation and a slowing trajectory that may raise concerns later on. The ECB is keen to avoid replicating the error made by Jean-Claude Trichet, who acted hastily in 2012, leading to the collapse of several Greek and Italian banks and triggering a 14-year period of Euro instability. Notably, the ECB operates under a single mandate, distinguishing itself from the Federal Reserve, which manages two mandates.

Currently, the ECB has communicated no intention to engage in rate cuts, opting to maintain higher rates until the data supports such a shift, particularly if inflation consistently remains below the 2% threshold.

Given the current scenario, we work with the available information. According to the latest dot plots, the Federal Reserve anticipates three rate cuts, while market sentiment hints at eight cuts in 2024, not all of which have been fully factored in yet.

Comparing the current interest rates:

Federal Reserve:
Current: 5.500%
Priced in (10-year): 3.8% (1.7%)

European Central Bank:
Current: 4.500%
Priced in (10-year): 2% (2.5%)

The existing interest rate differential is expected to continue narrowing towards 0.8%, propelling the EURUSD higher to around 1.20-1.23 by year-end as new data confirms the U.S. trajectory toward disinflation. While this ascent may not follow a linear path, periodic reevaluation of the trade (around 1.15-1.17) will be necessary as quarterly data is released. There's potential for an accelerated upward movement on EURUSD, reminiscent of the 2017-2018 surge from 1.05 to 1.25.

With the trade idea now taking shape, the focus shifts to volatility parameters. These factors will dictate trade size, determine permissible drawdown levels before exiting, and guide decisions regarding necessary hedges. Details on these considerations will be explored in future posts.

For full transparency, my P&L (+700%) is readily available on my profile page, along with information on my community.

Wishing fellow traders a successful hunt and a happy new year.
Beyond Technical AnalysisDXYEURUSDFundamental Analysisfundamental-analysis

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