Short-term rates and growth differential support a stronger US dollar in the period ahead. The EUR/USD exchange rate looks particularly vulnerable judging by the US dollar index vs. central banks’ policy rate differential.
The market expectations for the Federal funds rate in December 2020 have increased dramatically since the hawkish message delivered at the previous FOMC meeting. Because the EUR/USD exchange rate is inversely correlated to the Fed funds rate, the bias is that the US dollar will tend to appreciate in the months ahead.
The US dollar index also points to a reversal when compared to the central banks’ policy rate differential. As over 50% of the index is made up of the EUR/USD, traders have a second incentive to be cautious when bidding for the EUR/USD exchange rate.
The Return to Full Employment
The Federal Reserve’s mandate centres on price stability and job creation. The threshold for price stability is average inflation around the 2% target, while for job creation it is full employment.
How does the Fed define full employment? After the 2008-2009 Great Financial Crisis, the Fed was one of the fewest central banks to start a tightening cycle. Judging by how the economy recovered after the previous crises, we may draw the following conclusions.
First, the economic recovery tends to take a minimum of twenty quarters until full employment is reached. Second, 80% appears to be the de facto level for full employment according to the Fed. Hence, we may say that the threshold for full employment is 80%, and only when the number of employed people in the economy comes close to the level, the Fed will start a new tightening campaign.
The Fed did raise the Federal funds rate only in the second half of the last decade. With employment improving continuously, the Fed raised rates to 2.75%, but the economy reached the full employment threshold only in late 2018 and early 2019.
If history offers any guidance, the quicker the economy returns to full employment, the earlier the Fed will raise the rates. So far, the market expectations for the Federal funds rate point to the EUR/USD dropping to 1.17 and below. But if expectations continue to rise, the EUR/USD will have a hard time bottoming.