Dollar volatile as Fed pauses rate hikes

Important calendar events

• JPY: Core Machinery Orders, Trade Balance, Tertiary Industry Activity
• EUR: French Final CPI, Trade Balance, Eurogroup Meetings, Main Refinancing Rate, Monetary Policy Statement, ECB Press Conference
• USD: Retail Sales, Core Retail Sales, Empire State Manufacturing Index, Unemployment Claims, Philly Fed Manufacturing Index, Industrial Production, Capacity Utilization Rate, Business Inventories

USD

The dollar dipped in early trading on Wednesday, with the dollar index dropping to 102.7, but soared above 103.2 after the conclusion of the Fed meeting. US Treasury yields were also volatile, with the US 10-year bond yield ranging between 3.77% and 3.83%.

The U.S. Federal Reserve kept its interest rate steady at its policy meeting on Wednesday for the first time in well over a year. Fed officials have voted to keep the central bank’s interest rate at a target range of 5.00% to 5.25%. 

The Fed signaled on Wednesday, however, that its tightening cycle is not over yet and that its peak rate might be higher than anticipated. The FOMC policy statement following the conclusion of the meeting was hawkish, hinting at further rate hikes. The purpose of suspending rate hikes is to give policymakers time to assess the pace of cooling inflation and many economists believe that the Fed may resume rate hikes as early as July if inflation remains sticky. The Fed warned that additional firming may be appropriate. US Federal Reserve Chair Jerome Powell has also warned that the labor market remains very tight. 

US Headline inflation dropped sharply to 4.0% year-on-year in May, from 4.9% in April. US Inflation cooled more than expected in May, as markets were anticipating a 4.1% print. Core CPI, on the other hand, which excludes food and energy, remained sticky at 0.4% every month and 5.3% on an annual basis. US headline inflation dropped to its lowest point since March 2021 after 12 consecutive months of declines. Easing inflation enhances the odds of a pause in rate hikes at Wednesday’s Fed meeting.

US Producer Price Index data released on Wednesday confirmed that US inflation is starting to ease. PPI declined by 0.3% in May, against expectations of a 0.1% drop and a 0.2% growth in April. Annual PPI dropped from 2.3% to 1.1%, while core PPI fell from 3.2% to 2.8% year-on-year, beating estimates of 2.9%.

The US economy expanded by 1.3% in the first year of 2023 against predictions of a 1.1% growth. The preliminary GDP Price Index, which is an important inflation gauge, exceeded expectations, rising by 4.2% in Q1 of 2023 versus the 4.0% anticipated. 

Several important economic activity indicators are scheduled to be released on Thursday for the US, including Retail Sales and Unemployment Claims. These may cause some volatility in dollar prices in the wake of Wednesday’s Fed meeting. 

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EUR 

The Euro gained strength against the dollar on Wednesday, with EUR/USD touching the 1.086 level. If the currency pair goes up, it may encounter resistance near 1.090. If the EUR/USD pair declines, it may find support at 1.067. 

The ECB will announce its main refinancing rate this week on Thursday. The ECB raised interest rates by 25 bp at its latest monetary policy meeting, bringing its main refinancing rate to 3.75%. The ECB had raised interest rates by 50 bp in previous meetings and is slowing down the pace of rate hikes. The ECB has left the door open for further rate hikes as inflationary pressures in the EU remain high. 

The ECB is widely expected to hike its benchmark rate by 25 bps at its meeting on Thursday. ECB President Christine Lagarde has warned that inflationary pressures in the Eurozone remain high and that borrowing costs will be raised further to tackle them. Lagarde’s comments point to further rate hikes up ahead, while the US Fed has signaled a pause in rate hikes.

Market participants will follow closely the ECB Monetary Policy Statement and Press Conference after the conclusion of the meeting for hints on the central bank’s future policy direction. Many analysts anticipate that the ECB’s hawkish policy will continue and that the central bank will not signal a pause in its tightening path after Thursday’s meeting. As the Fed decided to keep its interest rate steady on Wednesday, a hawkish ECB statement may boost the Euro even further compared to the dollar.

Headline inflation in the Eurozone cooled to 6.1% year-on-year in May from 7.0% in April, beating expectations of 6.3%. Core Inflation, which excludes food and energy, also slowed to 5.3% on an annual basis in May versus 5.6% in April and 5.5% forecast. The latest inflation print is showing that the ECB’s efforts to bring inflation down are paying off, but it will likely not be sufficient to induce the central bank to abandon its hawkish policy just yet.

GDP data for the first quarter of the year showed that the Eurozone is technically entering a recession. Revised GDP showed a contraction of 0.1% for Q1 of 2023, in contrast to the Flash GDP data released earlier which showed an expansion of 0.1%. Deteriorating economic conditions in the Eurozone may force the ECB to rethink its hawkish monetary policy. 

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GBP

The Sterling strengthened on Wednesday, with GBP/USD rising to 1.270. If the GBP/USD rate goes up, it may encounter resistance near 1.270, while support may be found near 1.236. 

Upbeat economic GDP data boosted the Sterling on Wednesday. GDP data showed that Britain’s economy expanded by 0.2% month-on-month in April after a contraction of 0.3% in March. GDP grew by 0.1% for the 3-month figure to April pointing to slow growth and cooling recession concerns. In addition, the Services sector pushed higher by 0.3% in April after a fall of 0.5% in March. Construction Output, however, contracted by 0.6% in April against a 0.2% growth in March. Industrial and Manufacturing Production both declined by 0.3% every month in April, dropping below expectations of a 0.1% decline. 

A climate of political instability pushed the Sterling down this week. Former Prime Minister Boris Johnson and two fellow lawmakers resigned over the weekend. The ongoing feud between the former PM and the current PM Rishi Sunak has put pressure on Sterling.

The BOE is expected to increase interest rates in the coming months as it fights to bring inflation down. BOE governor Andrew Bailey has warned that inflation in the UK is persistent and will require further tightening to get inflation to target. Bailey stated on Tuesday, that inflation is taking longer to come down than anticipated, increasing market odds of future rate hikes.

The BOE raised interest rates by 25 basis points at its latest meeting in May, bringing the bank rate to 4.5%. Market odds are in favor of more BOE rate hikes up ahead and many analysts predict no rate cuts at all within the year. The BOE has been following an aggressively hawkish monetary policy, aiming to bring inflation down. As the US has signaled a pause in rate hikes, BOE interest rates may soon catch up with Fed rates, boosting the Sterling.

The UK’s weak economic outlook limits policymakers’ ability to increase interest rates sufficiently to rein in inflation. The British economy is struggling, and policymakers will have to assess how much tightening it can withstand to bring inflation down.

Headline inflation in the UK dropped below 10% on an annual basis in April for the first time since August 2022. Inflation in the UK is starting to cool, although not as rapidly as anticipated. Headline inflation rose by 8.7% year-on-year in April from 10.1% in March, surpassing expectations of 8.2%. Core CPI, which excludes food and energy, however, rose to 6.8% on an annual basis in April from 6.2% in March.

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JPY

The USD/JPY on Wednesday was mainly driven by the dollar. The currency pair dropped to 139 in early trading but was catapulted above the 140 level after the Fed rate decision. If the USD/JPY pair declines, it may find support near 138.5. If the pair climbs, it may find resistance at 140.5. 

The BOJ is holding its monetary policy meeting this week on Friday, the 16th. The BOJ maintained its dovish monetary policy at the bank’s previous meeting in April. This was the first meeting with the newly-appointed BOJ Governor Kazuo Ueda at the helm. Ueda has stated that monetary policy would remain accommodative until the bank’s 2% inflation target became sustainable. He also predicted that price pressures would fall sharply in the next year.

Japanese policymakers are expected to maintain the bank’s ultra-low interest rates on Friday, keeping the central bank’s refinancing rate at -0.10%. The BOJ is also not expected to make any adjustments to its yield curve control program. The BOJ Monetary Policy Statement and Governor Ueda’s post-meeting news conference are expected to attract traders’ attention. Japanese policymakers may take into account rising inflation rates. Increased price pressures raise the chance of the BOJ upgrading its inflation forecast in July, which may lay the groundwork for a change in policy down the road.

BOJ Core CPI rose to 3.0% year-on-year in April from 2.9% in March. April’s print exceeded expectations of a 2.8% growth, indicating that price pressures in Japan continue to rise. Tokyo Core CPI for April was also hotter than expected, at 3.5% on an annual basis, against expectations of a 3.2% print. Inflation in Japan remains steadily above the BOJ’s 2% target, putting pressure on businesses and households. 

Final GDP data for the year's first quarter released last week showed that the Japanese economy expanded by 0.7%, against a preliminary GDP print of 0.4%. The GDP data exceeded expectations, alleviating recession concerns for Japan. The final GDP Price Index printed showed a 2.0% annual expansion, versus 1.2% the previous quarter. Japan’s economic recovery increases the odds of a hawkish pivot in BOJ’s monetary policy.

Several economic activity indicators are scheduled to be released on Thursday for Japan. These include Core Machinery Orders and Trade Balance and may affect the Yen ahead of Friday’s BOJ policy meeting.

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Written by:
Myrsini Giannouli

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