Last Updated on 27 January 2021 by F.R.Costa

Investors are expecting too much from the FED, at a time real trouble lies in Europe, not in the U.S. The Euro is the side to sell, not the Dollar.

As I mentioned in Betting Against The Crowd On Interest Rates, investors are expecting too much from the FED. The U.S. are far from being in trouble, as the unemployment rate is near levels last seen in 1969 while growth is still healthy. If the Fed moves, it may wish to keep a few bullets at hand in case it really needs them in the future. However, the crowd’s view contrasts mine, as expectations for rate cuts are moving higher and higher, as reflected in the Fed Watch Tool.

By the time I wrote the aforementioned article, the market was placing odds of 69.3% on a 25 bps rate cut by the Fed on its 31 July meeting, with the remaining 30.7% pointing towards a bolder 50 bps cut. But, in one week, the odds were skewed towards a 50 bps cut, which is becoming highly likely. And that’s not all. An accumulated 75 bps cut is now seen as a fifty-fifty proposition for the October meeting. The problem is that economic data really doesn’t fit well in this rate path.

fed watch tool

While any action by the Fed by now would be considered preventive, the same is not the case for the ECB. With is refinancing rate held at zero and inflation stubbornly below the its 2% medium term target, the central bank is in real need to do something.

inflation euro area
Source: Eurostat. Chart: Made with Gretl.

The Eurozone economy is largely behind the U.S. in terms of economic health, showing many imbalances and slow growth, despite the asset purchase programme implemented by the ECB and the record low interest rates. In a recent speech, the ECB board member Benoit Coeure opened the door for dovish action from the central bank:

“Looking ahead, the Governing Council is determined to act in case of adverse contingencies and also stands ready to adjust all of its instruments, as appropriate, to ensure that inflation continues to move towards the Governing Council’s inflation aim in a sustained manner…”

In accordance, safe heaven debt yields are going down again, with the German 10-year government bond now yielding -0.30%. In Europe,the entire money market and a large part of the bond market are currently under water, where they will stay for long.

money market

When we compare Europe with the U.S., it’s tough to foresee any bullish prospects for the Euro for the time being. In my view, investors are being too optimistic on U.S. rate cuts and underestimating the need for action in Europe. The risks are on the Euro side and that’s why I believe the best place to be for the rest of the year is against the Euro in favour of the Dollar. The pair currently trades at 1.1227, but may well break below the 1.10 barrier.

About F.R.Costa

Filipe has more than 20 years experience with financial markets. He holds a degree in Economics with a specialisation in Finance and he's currently finishing a PhD in Finance. He used to work as financial consultant and research associate but then decided to return to academia five years ago. Since that, he has been an Invited Lecturer, teaching courses on Investments, Financial Markets, and Monetary Economics. He is also a regular contributor writer at The Master Investor Magazine.

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