• The US central bank is set to hike its policy rate by 50 basis points in May.
  • The Fed is also expected to start shrinking its balance sheet by $95 billion per month from June.
  • A 'buy the rumor sell the fact' market reaction could weigh on the dollar.

The US Dollar Index (DXY), which tracks the dollar’s performance against a basket of six major currencies, rose nearly 5% in April fueled by the Fed’s apparent willingness to tighten its policy in an aggressive way. The FOMC is widely expected to hike its policy rate by 50 basis points (bps) following the May policy meeting and unveil its plan to start shrinking the balance sheet by $95 billion per month from June.

Markets have been buying the rumor and the question on traders’ minds will be whether it will be the right time to sell the fact when the Fed announces its policy decisions on Thursday, May 4?

Hawkish scenario

According to the CME Group FedWatch Tool, markets are pricing a 94.5% probability of a total of 125 bps in the next two meetings. Additionally, the benchmark 10-year US Treasury bond yield is already up more than 50% since early March. Both of these market developments suggest that there isn’t much room for a hawkish surprise.

Nevertheless, in case FOMC Chairman Jerome Powell draws attention to ‘front loading’ rate increases and doesn’t outright dismiss a 75 bps hike in the near future, the dollar could continue to gather strength.

Additionally, it would also be dollar-positive if Powell downplays growth concerns and reiterates that they will stay focused on taming inflation, especially with the coronavirus-related lockdowns in China playing into supply chain issues.

Dovish scenario

The data published by the US Bureau of Economic Analysis showed that the Gross Domestic Product (GDP) decreased at an annual rate of 1.4% in the first quarter of 2022. Moreover, the annual Core Personal Consumption Expenditures (PCE) Price Index, the Fed’s preferred gauge of inflation, edged lower to 5.2% in March from 5.3% in February (revised from 5.4%). 

The Fed could voice its concerns over the heightened uncertainty surrounding the economic outlook and reassure markets that they will turn patient and watch the developments before deciding on the pace of future rate hikes. Moreover, an optimistic tone on the inflation outlook is likely to be seen as a dovish shift in language and weigh on the dollar.

Finally, the Fed’s quantitative tightening plan is expected to consist of a reduction of its holdings of US Treasury bonds and mortgage-backed securities by $60 billion and $35 billion, respectively, per month from June. If the Fed decides to shrink its balance sheet at a softer pace, the dollar is likely to come under heavy selling pressure.

Neutral scenario

The Fed might acknowledge the worsening economic outlook but argue that the economy and the labor market could handle aggressive rate hikes in the near term, which are necessary to battle inflation.

A 50 bps hike in May, a total reduction of $95 billion per month in the Fed’s holdings from June and an open door to more 50 bps rate increases in the upcoming meetings should be more or less in line with what the markets have been pricing. Thus, the initial ‘buy the rumor sell the fact’ market reaction in the neutral scenario is likely to hurt the dollar and trigger a long-overdue correction. 

Nonetheless, the policy divergence between the Fed and other major central banks should continue to support the greenback over the medium term.

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