US Dollar Forecast: US inflation returns to the fore

• US Dollar Index (DXY) reversed part of its pullback this week.
• The Fed’s interest rate cut in September appears almost priced in.
• US PCE should be the salient event next week.

Immediately to the upside comes the 200-day SMA

An auspicious second half of the week was enough to encourage the US Dollar (DXY) to close a week of decent gains and reverse two consecutive weekly retracements.

Indeed, the initial broad-based advance in the risk-linked universe sent the USD Index (DXY) to four-month lows in the 103.70-103.65 band, just to reverse that move in the last couple of days and reclaim the area beyond the 104.00 milestone in the context of an equally acceptable rebound in US yields across different time frames.

Despite the index breaking below the critical 200-day SMA earlier in the week, this was not a convincing breach, leaving the door open to the continuation of the recovery in the short-term horizon.

The divergence in monetary policy remains well in place 

The sharp decline in the DXY over the past week was solely driven by investors adjusting their expectations for the timing of a Federal Reserve (Fed) interest rate cut, which is now seen joining the majority of its G10 peers sooner than previously thought.

This adjustment kicked in soon after US inflation data, measured by the Consumer Price Index (CPI), fell short of consensus in June, while some cooling of the domestic labour market also helped in that matter.  

A glimpse at the central bank's space shows the European Central Bank (ECB) delivering a dovish hold on July 18 after trimming its interest rates by 25 bps in early June. The Swiss National Bank (SNB) unexpectedly cut rates by another 25 bps at its gathering last month, and the Bank of England (BoE) is now predicted to postpone a potential rate cut in August in light of the still sticky UK inflation figures. Furthermore, the Bank of Japan (BoJ) delivered a dovish message on June 14, and a rate hike in July looks unlikely for the time being. The exception, in the meantime, remains the Reserve Bank of Australia (RBA), as it is expected to begin its easing cycle in the second half of 2025.

Investors’ bets are placed on September and December

The increasing market speculation about an earlier start to the Fed's easing cycle was bolstered by positive data and a shift towards a not-so-hawkish narrative from some Fed officials.

With the re-emergence of a downward trend in domestic inflation and a recent slowdown in key areas such as the labour market and the services sector, market participants increased their exposure to the first rate cut in September, followed by an extra one in December. This expectation sharply contrasts with the Federal Open Market Committee's (FOMC) projection of just one rate cut, likely at the December 18 meeting.

However, the likelihood of a third interest rate reduction should involve an acceleration of the disinflationary pressures in combination with an incessant deterioration in the labour market; both scenarios are actually quite improbable. 

According to the CME Group's FedWatch Tool, there is approximately a 98% chance of rate cuts at the September 18 meeting, while lower rates in December are a done deal.

A “softening” of the Fed’s narrative opens the door to rate cuts

On Monday, Federal Reserve Chair Jerome Powell remarked that the three inflation readings over the second quarter "add somewhat to confidence" that the pace of price increases is returning to the Fed's target sustainably, indicating that interest rate cuts may not be far off. In addition, Federal Reserve Governor Adriana Kugler expressed cautious optimism that inflation is returning to the bank’s 2% goal, with goods, services, and housing contributing to easing price pressures. Furthermore, New York Federal Reserve President John Williams, argued that an interest-rate cut could be warranted in the coming months. Finally, Federal Reserve Governor Christopher Waller mentioned that the time for an interest rate cut "is drawing closer," although he noted that uncertainty about the economic path makes the timing of a reduction in short-term borrowing costs unclear.

It’s the economy! (as well)

Monetary policy divergence is predicted to remain a key player when it comes to potential extra gains in the Greenback. This likely uptrend also finds common ground with the persistent carry trade, while firm expectations of a “soft landing” of the US economy should also emerge as a significant factor underpinning the view of a stronger Dollar in the long run.

Upcoming key events

Moving forward, next week should be a very interesting one in terms of data releases, as flash Purchasing Manages Indexes (PMIs) are due for the month of July, seconded by the advanced GDP Growth Rate in the April-June period, and inflation gauged by the Personal Consumption Expenditures (PCE).

Techs on the US Dollar Index

Further recovery should place the key 200-day SMA at 104.39 as the immediate target for bulls. Once this region is surpassed, DXY is expected to meet its next resistance of note at the June high of 106.13 (June 26), prior to the 2024 top of 106.51 (April 16). Further north from here is the November peak of 107.11 (November 1), ahead of the 2023 high of 107.34 (October 3).

On the other hand, if bears regain the upper hand, the index could initially slip back to the July low of 103.65 (July 17) ahead of the weekly low of 103.17 (March 21). Down from here emerges the March low of 102.35 (March 8), followed by the December bottom of 100.61 (December 28), all preceding the psychological 100.00 milestone.

The DXY should regain its constructive outlook once it clears the 200-day SMA on a sustainable fashion.