Inflation and oil are two problems for the Fed

EUR/USD

Key zone: 1.1380 - 1.1450

Buy: 1.1450 (on strong positive fundamentals) ; target 1.1650-1.1700; StopLoss 1.1380

Sell: 1.1350 (on a pullback following a retest of 1.1400) ; target 1.1150; StopLoss 1.1420

The Federal Reserve has once again found itself at the center of one of the most difficult periods in recent years. Major institutional investors continue to expect interest rate cuts, while financial markets are increasingly pricing in the possibility of another rate hike within the next few months.

The divergence in expectations is driven by high uncertainty surrounding inflation, energy prices, and the outlook for U.S. economic growth.

To recap:

• Economists expect the first 25-basis-point rate cut only in the third quarter of 2027.
• Futures markets see the possibility of another rate hike as early as September.
• Core inflation remains elevated at 3.4%.
• Oil prices near $100 per barrel increase the risk of a new wave of inflationary pressure.

The forecast for rate cuts has already been pushed back by one quarter compared with expectations in June. At the same time, analysts' estimates continue to differ significantly from market expectations, as investors increasingly consider the possibility of additional monetary tightening.

Inflation remains the main source of uncertainty. The Federal Reserve's July report noted that:

• the PCE index rose to 4.1%;
• the energy component of PCE increased by 24% compared with the previous year;
• the conflict in the Middle East remains one of the key sources of inflation risk.

Several Federal Reserve officials have already warned that if persistent inflation continues, the central bank may need to raise interest rates again.

At the same time, the current situation differs significantly, for example, from the inflation crisis of 2022. Back then, rising prices were driven by the recovery in global demand after the pandemic. Today, the main source of inflationary pressure comes from the supply side. Expensive oil is gradually raising the cost of fuel, logistics, air transportation, chemical products, and food.

This type of inflation presents a much more difficult problem for a central bank. Higher interest rates are virtually incapable of increasing the global supply of oil, which means that the effectiveness of traditional monetary policy is considerably lower.

Particular attention should be paid not only to the overall inflation rate, but also to the speed at which inflation spreads into the services sector. This process could ultimately persuade the majority of FOMC members to support a more restrictive monetary policy.

Such a substantial divergence in expectations has direct consequences for financial markets. Interest rate forecasts determine the dynamics of Treasury yields, mortgage costs, corporate borrowing expenses, and stock market valuations. If rate cuts are indeed delayed until 2027, financing costs will remain elevated for significantly longer than investors had expected.

What does this mean?

The market is now in an extremely unusual situation in which the same macroeconomic indicators support directly opposing conclusions about the Federal Reserve's future policy. That is why every new CPI, PPI, or PCE report triggers such a large-scale repricing of expectations.

The difference between the approaches of the Federal Reserve and the European Central Bank remains equally important. This divergence is currently having a much stronger influence on EUR/USD than most traditional macroeconomic indicators.

As long as the Federal Reserve demonstrates a greater willingness than the ECB to maintain restrictive monetary policy, the fundamental advantage will remain with the dollar. This supports demand for U.S. assets and increases pressure on the European currency.

However, if inflation in the United States begins to slow faster than in the eurozone, the situation could change rapidly. Any sustained easing of price pressures or shift in the Federal Reserve's rhetoric could become a catalyst for a new phase of euro appreciation.

So we act wisely and avoid unnecessary risks.

Profits to y’all!