During the previous recession, the dollar smile theory was formulated, suggesting an increase in the USD index against the background of an increase in demand for safe-haven assets at the beginning of the recession, its subsequent fall due to the aggressive monetary expansion of the Fed and, finally, new growth due to the outpacing dynamics of the US economy over their main competitors. Given the second wave of COVID-19, the introduction of new restrictions by European countries, and the increased risks of a double recession in the eurozone, one would assume that the dollar is entering the third stage of the cycle. Moreover, American business activity brings pleasant surprises. Unfortunately, the US dollar continues to retreat on all fronts.
There is no shortage of bearish forecasts for the USD index. Goldman Sachs expects it to fall by 6% in 2021, and Citi by 20%. The arguments include the recovery of the global economy, the reduction of political risks in the United States, and the reset of relations between Washington and Beijing. The medium and long-term outlook for EUR/USD may be bright, but what about deflation in the eurozone? With the ECB’s intention to ease monetary policy in December? The minutes of the previous meeting of the Governing Council help answer this question. A number of officials believe that the stabilization of the situation in financial markets undermines the effectiveness of additional monetary stimulus, and low, often negative rates on debt, push governments to excessive extravagance.
The split in the ECB ranks is a bullish factor for the euro. Moreover, the expansion of QE will further reduce the yield differential of Italian and German bonds, which in the current situation can be considered as a positive background for the EUR/USD rally.
Dynamics of EUR/USD and bond yields:
As for the dollar smile theory, it is possible that the second, rather than the third, stage of the cycle is currently taking place. Before starting to grow, the USD will be at the bottom for some time, while in 2021 its rate is likely to continue to fall. As evidence, we can cite an increase in the yield curve in the US, which is usually perceived as a bearish signal for the dollar.
The dollar smile theory:
Dynamics of the yield curve and the USD index:
In my opinion, if vaccines really help humanity defeat COVID-19, and Joe Biden doesn’t attack China as fiercely as Donald Trump did, the global economic recovery will increase the demand for risk and keep safe-haven assets in the black. As a result, the EURUSD pair will be able to continue the rally in the direction of 1.25.
Technically, if we assume that wave 4-5 of the Broadening Wedge pattern is not complete yet, then two main strategies can be used to buy the main currency pair. First, it makes sense to form long positions on pullbacks to the 23.6% and 38.2% Fibonacci levels, which correspond to 1.1865 and 1.1815. Secondly, a confident breakout of the resistances at 1.195 and 1.196 is also suitable for buying. The initial target is 1.2045.
EURUSD daily chart:
*The market analysis posted here is meant to increase your awareness, but not to give instructions to make a trade.