A week ago, I mentioned that the inability of the EUR/USD bulls to gain a foothold above the base of the 18th figure will be a sign of their weakness and create prerequisites for a correction. In fact, this is what happened: the main currency pair closes the five-day period by October 16 in the red zone, while the introduction of repeated restrictions in Europe due to COVID-19, uncertainty around the US presidential election, and the deterioration of macro statistics for Germany and the Eurozone can lead to the development of a pullback.
Investors often build a strategy on the divergence. And if the differences in economic growth and monetary policy in June-August played into the hands of the bulls of EUR/USD, the situation has changed significantly in the fall. The pandemic should be blamed for this. The epidemiological situation in the U.S. and Europe continues to worsen. The number of cases is growing, and Paris and London are talking about new restrictions. As a result, the COVID-19-related divergence supports the US dollar.
Dynamics of EUR / USD and the ratio of the number of infected in the US and EU:
In the summer, a more effective fiscal stimulus and competent management of the pandemic allowed the Euro to strengthen, but we must admit that the Fed's monetary policy has given a greater return than that of the ECB. This is clearly seen in the dynamics of inflation: in the U.S. an increase of 5% was recorded over the past three months, while Eurozone went down by 1%. Divergence in core inflation is a good leading indicator that allows you to predict the future dynamics of EUR/USD, and now it shows in favor of the correction of the main currency pair.
Dynamics of EUR / USD and the ratio of core inflation in the USA and the Eurozone:
Financial markets do not expect changes in the monetary policy of the Federal Reserve, but they do not mind seeing the expansion of the emergency asset purchase program to combat the pandemic by the European Central Bank. This gives grounds for higher yields on US Treasury bonds, while rates on their European counterparts, including Germany, Italy, Spain, and other countries, remain subdued. As a result, the negative correlation between assets has grown to the highest level in at least a decade, which is not good news for the euro.
Dynamics of 30-year US and German bond yields and correlation between debt rates:
Thus, divergences in the epidemiological situation, in core inflation, and in bond yields signal in favor of the development of a corrective movement in the EUR/USD pair. The only thing that can prevent a pullback is a "blue wave" – the Democrats' taking of the White House and Congress, which will increase hopes for fiscal stimulus and allow the S&P 500 to soar. While the market doubts that the Republicans will give up the Senate, the US dollar feels confident.
Technically, the rebound from the lower border of the shelf (range 1.18-1.19) of the Splash and shelf pattern indicates the seriousness of the EUR/USD bears' intentions to develop a correction. They are set to activate the AB=CD model with a target of 161.8%. It is located near the 1.149 mark. Our recommendation is selling on pullbacks.
EUR / USD, daily chart:
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