This report provides a comprehensive analysis of the current market fundamentals affecting the US dollar (USD), examining fiscal policy, economic indicators, and monetary policy developments. It delves into the factors that have influenced USD movements over the past five months and five weeks, and assesses the potential influences on the currency in the coming five months and five weeks. The report concludes with a summary of key findings and a list of referenced sources.

Fiscal policy

The proposed FY 2025 US budget reveals an expansionary fiscal stance, prioritising investments in clean energy, affordable housing, education, and healthcare while aiming for deficit reduction through increased taxation on corporations and high-income earners. The budget projects a deficit of $1.677 trillion for FY 2024, decreasing to $7.894 trillion over the subsequent five years (FY 2025-2029). This reduction stems from proposed tax reforms targeting corporations and high-income individuals, including a 25% minimum tax on billionaires, an increase in the corporate tax rate to 28%, and the closure of various tax loopholes. (""Budget of the U.S. Government, Fiscal Year 2025,"" p. 45). These measures are projected to generate approximately $3 trillion in deficit reduction over the next decade.

However, the budget also proposes significant spending increases, notably a new program guaranteeing affordable childcare for working families with incomes up to $200,000 per year. (""Budget of the U.S. Government, Fiscal Year 2025,"" p. 16). This program, along with expansions of existing social safety net programs, could contribute to a weaker USD if it leads to increased government borrowing and a perception of looser fiscal policy.

The U.S. Gross Federal Debt to GDP ratio, a key indicator of the country's fiscal health, stood at 122.30% in 2023. This figure exceeded initial market expectations and reflects a continued upward trend since the ratio peaked at 126.30% in 2020. Trading Economics forecasts the ratio to reach 124.30% by the end of 2024, aligning with the upward trajectory. Looking further ahead, econometric models project the ratio to trend around 126.40% in 2025 and 127.80% in 2026. Achieving these projections hinges on the government's ability to balance its ambitious spending plans with its proposed revenue-generating measures. The effectiveness of these measures in curbing the deficit and stabilising the debt-to-GDP ratio remains to be seen. The sustained high level of U.S. debt poses a potential risk to the USD, particularly if it fuels concerns about the long-term sustainability of U.S. fiscal policy.

Economic overview

Over the past five months, the US economy has shown signs of cooling. Real GDP growth slowed from 4.9% in Q4 2023 to 1.3% in Q1 2024. (""Real Gross Domestic Product and Related Measures: Percent Change from Preceding Period"", p. 1). Trading Economics forecasts US GDP growth to be 1.5% by the end of Q2 2024 and projects a long-term trend of around 1.8% in 2025. (""US GDP Growth Rate""). While the 1.5% forecast for Q2 is achievable, the projected 1.8% growth for 2025 will depend on factors such as consumer spending, business investment, and global economic conditions.

The US labour market has remained robust, with strong job gains and a low unemployment rate. However, recent data suggests that the pace of job growth is slowing, and wage pressures are easing. Nonfarm payrolls increased by 175,000 in April, a deceleration from the upwardly revised 315,000 jobs added in March but still a solid gain. (""The Employment Situation — April 2024"", p. 1). The unemployment rate unexpectedly ticked up to 3.9% from 3.8% in March, exceeding market expectations. (""US Unemployment Rate""). Average hourly earnings for all employees on private nonfarm payrolls edged up by 0.2% to $34.75 in April, below market estimates of a 0.3% rise. Over the year, average hourly earnings have increased by 3.9%, the least since June 2021. (""US Average Hourly Earnings MoM"" and ""US Average Hourly Earnings YoY"").

Inflation has shown signs of moderating, but remains above the Federal Reserve's 2% target. Inflation in the US eased to 3.4% in April from 3.5% in March, matching market forecasts. This marks the lowest reading since September 2023. Core inflation, which excludes volatile food and energy prices, also slowed to 3.6% annually, the lowest reading since April 2021. (""US Inflation Rate""). The US core PCE price index, the Federal Reserve's preferred gauge to measure inflation, rose by 0.2% from the previous month in April after a 0.3% increase in March. (""US Core PCE Price Index MoM"").

The US trade deficit has remained elevated, reflecting strong domestic demand and a weaker global economy. The US trade deficit remained almost unchanged at ten-month highs of $69.4 billion in March, compared to an upwardly revised $69.5 billion in February. (""US Balance of Trade"").

Monetary policy

The Federal Reserve maintained a hawkish stance in its May meeting, holding the target range for the federal funds rate at 5.25%-5.50% (""Federal Reserve press release,"" May 1st, 2024). This decision reflects the FOMC's ongoing concern about inflation, despite its easing over the past year. The Committee explicitly acknowledged the ""lack of further progress toward the Committee’s 2 percent inflation objective in recent months"" (""Minutes of the Federal Open Market Committee,"" April 30th-May 1st, 2024).

Chair Powell, in his press conference, emphasised that the Fed would need ""greater confidence that inflation is moving sustainably toward 2 percent"" before considering any rate cuts (""Transcript of Chair Powell’s Press Conference,"" May 1st, 2024). This statement, coupled with the unchanged interest rate, signals a commitment to maintaining a restrictive monetary policy stance for the foreseeable future.

The Summary of Economic Projections from March shows a median projection for the federal funds rate of 4.6% at the end of 2024, 3.9% at the end of 2025, and 3.1% at the end of 2026 (""Summary of Economic Projections,"" March 20th, 2024). However, given the Fed's current hawkish stance and the persistent inflationary pressures, achieving these projections appears less likely. The Fed's communication suggests a longer period of elevated interest rates may be necessary to bring inflation back to the 2% target.

While maintaining a hawkish hold on interest rates, the Fed decided to slow the pace of quantitative tightening (QT) from June 1st, 2024. The monthly redemption cap on Treasury securities will be reduced from $60 billion to $25 billion, while the cap on agency debt and agency mortgage-backed securities will remain at $35 billion (""Minutes of the Federal Open Market Committee,"" April 30th-May 1st, 2024). The Fed emphasised that this decision was primarily for operational reasons, ensuring a smooth transition from abundant to ample reserve balances and does not signal a change in the ultimate size of the balance sheet.

Over the past five months, the Fed's monetary policy has evolved from a focus on aggressive rate hikes to a more cautious approach. The shift is evident in the unchanged interest rate in May, following consecutive increases in the previous meetings. The Fed's communication has also become more data-dependent, emphasising the need for clear evidence of sustained disinflation before considering any policy easing.

The benchmark interest rate in the United States, the US Fed Funds Interest Rate, was last recorded at 5.50 percent. This matches the current target range of 5.25%-5.50%. Trading Economics global macro models and analysts expectations predict the rate to remain at 5.50 percent by the end of this quarter. In the long-term, the US Fed Funds Interest Rate is projected to trend around 4.25 percent in 2025 and 3.25 percent in 2026, according to Trading Economics econometric models. However, considering the Fed's current hawkish stance and the uncertainties surrounding inflation, achieving these longer-term projections might be challenging. The Fed's commitment to maintaining a restrictive policy until inflation is convincingly on a downward path to 2% suggests a potential for higher rates for longer than currently anticipated by market forecasts.

Looking-back

Five-month influences: Over the past five months, the USD has experienced a period of depreciation against major currencies like the euro and the pound. This can be attributed to a combination of factors, including:

  • Shifting interest rate differentials: The Federal Reserve's aggressive rate hikes in the early part of the year initially supported the USD. However, as other central banks, particularly the European Central Bank, began to signal their own intentions to tighten monetary policy, the interest rate differential between the US and other major economies narrowed, reducing the attractiveness of the USD.
  • Moderating inflation: While US inflation remains above the Fed's target, it has shown signs of easing in recent months. This has led to market expectations that the Fed may soon pause its rate hiking cycle, further diminishing the USD's appeal.
  • Concerns about US economic growth: The slowdown in US GDP growth in Q1 2024 has raised concerns about the health of the US economy. This has contributed to a flight to safety, with investors seeking refuge in currencies perceived as less risky, such as the euro and the Swiss franc.

Five-week influences: In the past five weeks, the USD has experienced mixed performance, with gains against some currencies offset by losses against others. Key influences include:

  • Easing US inflation concerns: The release of the US core PCE inflation data for April, which came in line with expectations, eased concerns about an overly hawkish Federal Reserve and prompted a decline in the US dollar. This data increased market expectations for a Fed rate cut later this year.
  • Surprise BoJ policy shift: The Bank of Japan's decision to cut the amount of JGBs it offered to buy in a regular operation spurred bets on potential quantitative tightening in the future and drove Japanese bond yields higher, strengthening the Japanese yen against the USD.
  • Hawkish SNB commentary: SNB Chairman Thomas Jordan's suggestion of a ""small upward risk"" to the inflation forecast reduced the likelihood of a June SNB rate cut, leading to a strengthening of the Swiss franc against the USD.
  • Mixed US economic data: While US Durable Goods Orders for April surprised to the upside, defying market expectations of a decrease, US retail sales data for April came in below expectations, suggesting a slowdown in consumer spending. This mixed data did not significantly alter the outlook for Fed policy or the USD.

Latest and looking-ahead

Five-month potential influences: Looking ahead, the USD's trajectory will likely be influenced by:

  • Federal Reserve policy: The Fed's future policy decisions will be crucial for the USD. If the Fed maintains its hawkish stance and continues to raise interest rates, the USD could strengthen. However, if the Fed signals a pause or pivot in its policy, the USD could weaken.
  • US economic performance: The health of the US economy will also be a key driver for the USD. Strong economic growth could support the USD, while a further slowdown could weigh on the currency.
  • Global risk appetite: Geopolitical events and global economic conditions will continue to influence risk appetite. If risk aversion increases, the USD could benefit from its safe-haven status. However, if risk appetite improves, the USD could weaken as investors seek higher-yielding assets.

Five-week potential influences: In the next five weeks, the USD could be influenced by:

  • OPEC+ meeting: The upcoming OPEC+ meeting on Sunday, June 2nd, could have a significant impact on oil prices and risk appetite. An extension of production cuts is widely expected, but any surprise decision could trigger volatility in oil markets and broader financial markets, potentially impacting the USD.
  • Central bank decisions: The ECB interest rate decision on Thursday, June 6th, and the Bank of England interest rate decision on Wednesday, June 5th, could impact the EUR/USD and GBP/USD exchange rates, respectively.
  • US Nonfarm Payrolls report: The US Nonfarm Payrolls report for May, due on Friday, June 7th, will be a key data point for assessing the health of the US labour market and could influence Fed policy expectations and the USD.

Conclusion

The USD is currently facing a confluence of factors that are contributing to its mixed performance. While the Fed's hawkish stance and the relative strength of the US economy provide some support for the currency, concerns about slowing growth, moderating inflation, and narrowing interest rate differentials are weighing on the USD.

Looking ahead, the USD's trajectory will depend on the Fed's policy decisions, the performance of the US economy, and global risk appetite. Key events in the coming weeks, such as the OPEC+ meeting and the release of the US Nonfarm Payrolls report, could trigger significant volatility in the USD.

 

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