AUD/USD strong correlation to DXY in focus ahead of FOMC

AUD/USD is a touch higher in North American trade rising 0.34% at the time of writing to 0.7754 from a low of 0.7717 and slightly below the high of the day at 0.7763.

The focus has been on the US dollar this week while investors moved to the sidelines in anticipation of critical events in the US.

US Consumer Price Index and the European Central Bank were occurring earlier today ahead of the Federal Reserve next week. 

The dollar index was down slightly on Thursday in a choppy session in which it alternated between losses and gains.

The greenback had been building on its modest gains ahead of the ECB decision and US CPI data and was up for a third straight day, trading at the highest level since Monday at around 90.30. 

However, the index drifted lower into what was a relatively disappointing reaction in forex markets considering the anticipation leading into the events today. 

Forex volatility is at its lowest since the turn of 2020 and markets were hoping for a boost out of the US dollar today and some direction:

Instead, volatility remains low and traders are sat on their hands awaiting the Fed next week. 

Thursday's news appeared to add little new direction to currency markets and the greenback is stuck in familiar ranges:

DXY hourly chart

''A clean break above 90.325 is needed to set up a test of last week’s pre-NFP high near 90.627,'' analysts at Brown Brothers Harriman argued. 

As for the data, the CPI rose 0.6%, with core up 0.7%, stronger than expected. Also, the US CPI rose 5.0% from a year ago - the largest annual gain in more than a decade

Underlying inflation pressures are firming as the economy reopens but while the surge in year-over-year CPI growth to a 5.0% rate in May was stronger-than-expected, it was not entirely a surprise given the potential changes as the economy re-opens.  

''All in all, strong core data again, but the strength can probably still be viewed as "transitory" to a large extent, due to post-COVID reopening as well as fallout from the semiconductor shortage,'' analysts at TD Securities argued.

''We don't think this report materially changes the Fed's thinking as much of the strength remains confined to reopening-related sectors.''

''... it would take a string of strong CPI reports later this year for the Fed to get concerned about an earlier overshoot.''

However, looking to the Fed, there could be a hawkish surprise that would be expected to underpin the US dollar for the medium term.

FOMC priced too dovish

Low volatility in the forex and rates space suggests that the market is already priced for a fairly dovish tone from the FOMC next week.

However, analysts at TD Securities argue that the tone will probably be slightly less dovish than in April.

''We expect the chair to say that the committee has started discussing a progress-dependent tapering plan while also emphasizing that action will require much more progress.''

''Median projections for core inflation in 2022/2023 will probably rise slightly, consistent with a sizable revision to 2021 being viewed as "largely reflecting transitory factors." The median dot will probably show a rate hike by end-23.''

''A less dovish Fed tone next week would help to stabilize the USD in the very short run.''

''Of course, it may not reverse all of Q2's weakness, but positioning has turned short once again, real rates might be bottoming, and global growth shows signs of pausing. All signs to expect some USD stability as we enter the summer months.''

RBA and domestic factors in focus

Meanwhile, from a domestic front, tension is rising over the Reserve Bank of Australia's policy decision in July.

The RBA is edging towards a key policy shakeup in July.

In the lead-in, we will hear from the RBA's Governor Phillip Lowespeech next week, shortly before Australia's May jobs data.

We will also have RBA’s June minutes next week that will also be read closely.  

Meanwhile, the correlation of changes in DXY and AUD/USD is very high even in historical context.

(Hourly/daily charts)

''We suspect AUD/USD sees choppy price action postFOMC but with fair value 0.84+, are happy to remain long from 0.7680, adding on dips to 0.7580,'' analysts at Westpac said.

''If Lowe gives clear support to those calling for QE tapering and May jobs rebound, the gap to fair value should shrink.''