05:22 AM EDT, 04/16/2024 (MT Newswires) -- Selling the euro and betting on further losses for the Swedish krona are two of the best ways to trade an expected divergence between interest rates at the Federal Reserve and those at other central banks, analysts at Goldman Sachs said.

Selling EUR/CAD and buying USD/SEK call options are two of the preferred trades for capitalizing on a more hawkish outlook for US interest rates relative to the rest of the developed world, Goldman analysts said in a Friday note.

However, the euro is seen as likely to also fall further against the dollar in the short-term and to underperform relative to the Indian rupee.

"We have demonstrated that FX does not typically price policy divergence until the cycle is imminent (with perhaps some particular asymmetry in EUR), but we are now at least starting to approach that window, as the moves this week suggest," the analysts said.

"We continue to feature short EUR ideas prominently in our trade recommendations via short EUR/CAD (with a target of 1.44), short EUR/INR (with a target of 88), and indirectly by buying USD/SEK calls," they added.

European Central Bank policymakers have emerged as some of the most dovish in the G10 group, which leaves the euro especially vulnerable to the nascent hawkish repricing of market expectations for interest rates at the Fed.

There is a growing consensus on the Governing Council that favors cutting rates as soon as June with many also advocating multiple further cuts for later in the year, while overnight index swap rates have recently continued to imply that four rate cuts are likely this year.

Meanwhile, important barometers of the US economy have continued to consistently surprise on the upside of expectations in recent weeks with the latest being the March retail sales numbers released on Monday, which came in much stronger than expected.

"We also think it is worth noting something more simplistic: the US is the only economy in the G10 where the latest inflation print surprised to the upside," Goldman Sachs analysts said on Friday.

"We still think the better cyclical backdrop and currency management considerations should contain the extent of broad Dollar strength, but recent inflation pressures make it more likely that the policy-sensitive crosses, like EUR, will fall behind the dollar," they added.

Monday's retail sales surprise followed higher-than-expected March inflation figures released last week, which have been hailed as a watershed moment for financial markets and the interest rate outlook.

The March uptick in the annual inflation rate and continued elevation of the monthly reading have led economists and markets to abandon expectations for a June interest rate cut and prompted questions about whether the Fed will be able to cut rates at all this year.

One member of the Federal Open Market Committee, Mary Daly, has since said there is no rush for the Fed to cut interest rates while others have suggested the bank can afford to be patient in waiting for further confirmation that inflation will ultimately return to the 2% target.

"While it is too early to be fully in 'divergence mode' - our economists' still expect quarterly rate cuts, just starting a bit later - it is sensible for the market to price a higher probability of that outcome," the Goldman analysts said.

The dollar rose against all G10 counterparts in the week and month to Tuesday, further cementing it in place as the top performing currency of the year. The greenback had also risen against all G20 currencies over the same period with the sole exception being the Mexican peso.

Dollar gains have built steadily since January when US inflation figures and other economic barometers began to surprise on the upside of market expectations, culminating in a sharp rally last week when March inflation figures came in stronger than was expected.

Overnight index swap rates have shifted in recent months as a result to most recently imply that only two interest rate cuts are now likely to be announced this year, which is down from six in January and below the three envisaged in the latest FOMC forecasts.

"Recent market shifts are consistent with divergent data as we enter a critical period for policy decisions," the Goldman analysts said.