US Dollar Forecast: DXY extends gains as May PCE shows inflation receding

• US Dollar Index (DXY) extended its uptrend further.
• Market participants still see the Fed’s first rate cut in September.
• NFP and Powell should dictate the price action next week.

A visit to the 2024 top looms closer

Another positive week finally saw the Greenback surpass the key 106.00 barrier for the first time since early May, according to the US Dollar Index (DXY). Indeed, the Index advanced for the fourth week in a row, once again on the back of the growing divergence in monetary policy between the Federal Reserve (Fed) and most other G10 central banks.

Monetary policy divergence and inflation

A closer look at the recent performance of the US Dollar (USD) reveals that it has managed to regain further strength against the broad risk-associated space since the FOMC June 12 meeting, in which the Fed largely met investors’ expectations by keeping the Fed Funds Target Range (FFTR) unchanged at 5.25%–5.50%, and the drop in US inflation reflected by the Consumer Price Index (CPI).

Among the G10 central banks, the European Central Bank (ECB) reduced its rates by 25 bps early in June. The Swiss National Bank (SNB) surprised markets with an additional 25 bps cut on June 20, while the Bank of England (BoE) issued a dovish hold on the same day. Similarly, the Bank of Japan (BoJ) conveyed a dovish message on June 14. 

In contrast, the Reserve Bank of Australia (RBA) is expected to start easing in the first half of next year, while the Fed might begin reducing its rates by the end of this year, according to their latest meeting. It is worth recalling that the Federal Open Market Committee (FOMC) also indicated only one interest rate cut this year, likely at the December 18 event.

However, the reemergence of disinflationary pressure, as per the CPI and Friday’s Personal Consumption Expenditures (PCE) report, along with a slowdown in key areas such as the US labour market in recent weeks, seem to have prompted market participants to start pencilling in two interest rate cuts by the central bank this year, likely in September and December.

One or two interest rate cuts?

A large driver behind the strong performance of the Greenback as of late must be found in the resilient, hawkish tone of the majority of Fed officials. All in all, while policymakers acknowledged the importance of inflation coming down, they still showed a persistent lack of confidence that this downward trend is sustainable.

These past few days, the President of the Federal Reserve Bank of Chicago, Austan Goolsbee, and Mary Daly, President of the San Francisco Federal Reserve Bank, have expressed confidence that inflationary pressure is easing, with Daly not believing the bank should cut rates until they are confident that inflation is moving towards 2%. 

In addition, Fed Governor Lisa Cook has indicated that the bank is on track for a rate cut if the economy's performance aligns with her expectations. Her colleague Michelle Bowman believes that inflation will decline further with the policy rate held steady, and rate cuts will be appropriate if inflation moves sustainably towards 2%. Finally, Atlanta Fed President Raphael Bostic believes inflation is narrowing, allowing the Fed to cut interest rates later this year.

Nevertheless, according to the FedWatch Tool by CME Group, there is approximately a 68% chance of lower rates at the September 18 meeting and nearly a 95% likelihood by the end of the year.

US yields do not validate US Dollar’s advance yet

The continuation of the intense upward momentum in the Greenback following the FOMC hiccup has not been reflected in US yields so far. In fact, yields have maintained their consolidative mood unchanged since the beginning of June at the lower end of the range.

Fed's hawkish tone and inflation trends challenge market expectations of rate cuts

To sum up, persistent hawkish Fedspeak favouring extra patience and further evidence of inflation’s path toward the Fed’s target maintains its collision course with the market’s belief of two interest rate cuts in the latter part of the year.

The still unabated constructive bias in the Dollar appears to favour the Fed’s option, hence, the likelihood of an extra advance in the currency remains well on the table on the medium-term horizon.

Moving forward, Chief Powell’s participation in the ECB Forum at Sintra (Portugal) is expected to yield the same tone of recent comments, while the publication of the US labour market in the latter part of next week should prove to be more crucial in shedding further details on the Fed’s plans to start reducing its interest rates. 

Upcoming key events

A busy and interesting week lies ahead for the Dollar on the data front. Powell will speak at the ECB Forum early in the week, followed by the ADP report and results from key Manufacturing and Services PMIs by the ISM. In addition, the FOMC will publish its Minutes of the June meeting and June’s Nonfarm Payrolls emerge as the salient event towards the end of the week.

Techs on the US Dollar Index

The DXY maintained its firm momentum after bottoming out near 104.00 in early June, managing to finally trespass the key 106.00 hurdle.

If the index breaks above the June top of 106.13 (June 26), it might confront the 2024 high of 106.51 (April 16). Once it clears this region, DXY might embark on a probable visit to the November peak of 107.11 (November 1) ahead of the 2023 top of 107.34 (October 3).

On the other hand, the key 200-day SMA of 104.49 should offer decent initial contention before the June low of 103.99 (June 4). A deeper pullback could put the weekly low of 103.88 (April 9) back on the radar ahead of the March low of 102.35 (March 8) and the December bottom of 100.61 (December 28), all before the psychological contention zone at 100.00.

Meanwhile, the Dollar’s bullish outlook should remain intact while above the key 200-day SMA.