The dollar finally went into defense on Wednesday, the USD index broke through 96 points, the lowest since the start of June. Breaking down the index into components, it can be seen that the move was driven predominantly by strengthening of euro:

EURUSD

In the trade-weighted USD index euro has the biggest weight which also contributed to the magnitude of decline.

On Monday, we discussed a trading setup on EURUSD, I recommend that you carefully read my arguments why the common currency can easily discount July ECB meeting and why the long positions in the pair were (and most likely remain) justified.

The attention of the markets (including mine) was drawn by speeches of Fed’s “talking heads” yesterday. In short, officials continue to lament over “shrouded in a thick layer of fog” economic outlook while key stimulus programs expiring in a month. The head of the Federal Reserve Bank of St. Louis Bullard “expects” that Congress won’t stop halfway and approve at the end of this month a new “substantial” program to support firms and households. Depending on the size of the package, the Fed may need to step in with some asset-purchase program to prevent disruptions from the oversupply shock in the Treasury market. We know where that leads.

Of course, one can argue that the Fed and Congress should be constrained by inflation in their stimulus plans, however, Central Bank officials continue to insist that factors of strong disinflation have arisen and at work in the economy. Robert Kaplan cites the resulting excess of production capacities (the so-called overcapacity) as an argument. Let me explain what he means. When a consumption shock occurs, the demand curve quickly shifts to the left, which reduces the equilibrium prices in the economy (deflationary effect). However, the adjustment of the supply curve (reduction in production) takes longer (sometimes significantly), since the shock reveals excess capacity of manufacturers (+ oversupply of inventory) that cannot be quickly eliminated. This increases the time of adjustment. This leads to the situation where economy continues to produce more than can be sold and consumed for some time. And this is, of course, disinflationary.

As we see, Fed officials have both a desire and a sense of “impunity”, which is why new measures to support the economy are actively discussed, which have already shown how they can actively depreciate the dollar. Hence the market’s tendency to expect further weakening of the dollar, which, as we see, is gradually being realized. These expectations are also fueled by the deterioration of epidemiological situation in the United States, which objectively slows down the economy and dampens recovery, because individual states are careful in lifting lockdowns. The need for new stimulus and corresponding pressure on the US government is growing, which cannot be said, for example, about the EU, where the epidemic remains under control. This is an additional argument in favor of the strength of the euro against the dollar (i.e. underlying imbalance in stimulus expectations and recovery outlook).

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