US Dollar: Fed hike expectations and limited gains – MUFG

MUFG’s Lee Hardman notes that the US Dollar (USD) has strengthened only modestly even as markets price in a Fed rate hike at this week’s FOMC meeting. Stronger US inflation and a hawkish repricing at the short end of the US yield curve support the Dollar, but policy credibility risks, energy-driven inflation, and US mid-term election timing may cap near-term upside.

Dollar reacts cautiously to Fed repricing

"The US dollar has strengthened modestly at the start of this week encouraged by building expectations that the Fed will begin tightening monetary policy this week. It has helped to lift the dollar index back above support form the 200-day moving average at around 99.150. The US dollar has been boosted by the hawkish repricing at the short-end of the US yield curve triggered by stronger US inflation data last week."

"After the stronger US inflation data, the Fed is expected to begin their tightening cycle as soon as this week. There are currently 22bps of hikes priced in for this week’s FOMC meeting compared to around 15bps a week ago. Over the same period the dollar index has strengthened by just 0.3% highlighting that the positive impact on the US dollar from the hawkish repricing of Fed rate hike expectations has been surprisingly limited so far."

"If the Fed does not take action this week to address upside inflation risks, it could trigger a sharp sell-off for the US dollar and long-term US Treasuries by undermining confidence in their willingness to get on top of inflation. It could be one reason why US dollar gains have only been limited so far on the back of the hawkish repricing of Fed rate hike expectations. Market participants could be waiting for confirmation of policy action to open up further gains for the US dollar."

"US dollar strength in the near-term could also be curtailed by the close proximity of the US mid-term elections. Even if the Fed begin to hike rates today, they maybe reluctant to deliver a back-to-back hike at the next meeting on 28th October which comes just before the mid-term elections on 3rd November. The next hike may then not be delivered until 9th December."

(This article was created with the help of an Artificial Intelligence tool and reviewed by an editor. Know more.)