Dollar dips on dovish Fed rhetoric

Important calendar events

• JPY: Tertiary Industry Activity
• GBP: Claimant Count Change, Average Earnings Index, Unemployment Rate
• EUR: German ZEW Economic Sentiment, ZEW Economic Sentiment, ECOFIN Meetings
• USD: Retail Sales, Core Retail Sales, Industrial Production, Capacity Utilization Rate, Business Inventories, NAHB Housing Market Index, TIC Long-Term Purchases

USD

The dollar dipped on Monday and the dollar index dropped to 106.2. US bond yields on the other hand gained strength, with the US 10-year bond yielding approximately 4.71%. 

The recent crisis in Israel has increased risk-aversion sentiment, providing support for the safe haven dollar. Fears of the conflict between Israel and Hamas spreading further in the Middle East have turned traders towards safer investments. 

Fed rhetoric has turned dovish since last week, putting pressure on the dollar. Several policymakers made dovish statements last week, indicating that the Fed has likely reached its rate ceiling and that they might let high treasury yields do some of the work of tightening for them.

Fed rhetoric will be one of the main drivers of the dollar in the next few weeks as the dollar’s direction greatly depends on the Fed’s policy outlook. Fed chair Jerome Powell’s speech on Thursday, especially, is highly anticipated and is expected to create market volatility.

Fed rhetoric remained dovish on Monday, driving the dollar down. FOMC member Patrick Harker stated on Monday that the central bank should stop raising interest rates and hold rates where they are for some time.  

Markets anticipate that Fed interest rates will remain the same this year, with an approximately 90% probability of a pause at November’s meeting and a more than 70% probability of an end to rate hikes through 2023. The probability of another rate hike within the year has decreased, but the possibility of another increase in interest rates cannot be completely discounted and it is likely to affect the dollar in the coming weeks.

In September’s monetary policy meeting, FOMC members voted to keep interest rates unchanged at a target range of 5.25% to 5.50%. The Fed decided to pause rate hikes, but interest rates will likely remain in restrictive territory for longer.

Hotter than expected US inflation increased rate hike expectations. US headline inflation in September remained at August's levels of 3.7% year-on-year, while market analysts were expecting a drop to 3.6%. 

Core PCE Price Index dropped to 3.9% year-on-year from 4.3% in July. This is the Fed’s preferred inflation gauge and a lower-than-expected print indicated that price pressures in the US are easing. 

US inflationary pressures are not easing just yet though, despite the Fed’s high interest rates. Headline inflation came in hotter than anticipated, climbing to 3.7% year-on-year in August from 3.2% in July versus 3.6% expected. Rising fuel costs are largely to blame for the stubbornly high inflation rates in the US. 

Final GDP data for the second quarter of 2023 showed that the US economy expanded by only 2.1% in Q2 of 2023 against expectations of 2.2% growth. The final GDP price index for the 2nd quarter of the year also came in below expectations at 1.7% versus 2.0% anticipated.

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EUR 

The Euro gained strength against the dollar on Monday, and EUR/USD climbed to the 1.055 level. If the EUR/USD pair declines, it may find support at 1.049, while resistance may be encountered near 1.064. 

The ECB raised interest rates by 25 bp at its September monetary policy meeting, bringing its main refinancing rate to 4.50%. The ECB had the difficult task of assessing the risk to the fragile Eurozone economy against high inflation rates. 

The ECB has likely reached its interest rate ceiling, putting pressure on the Euro. ECB President Christine Lagarde has signaled an end to rate hikes but has warned that interest rates will remain at sufficiently restrictive levels for as long as necessary.

Headline inflation in the Eurozone fell to its lowest level in two years in September. Flash CPI cooled to 4.3% year-on-year in September from 5.2% in August against expectations of a 4.5% print. Core CPI Flash Estimate, which excludes food and energy, also came in cooler than anticipated. Core CPI eased to 4.5% in September from 5.3% in August versus 4.5% predicted. The ECB’s efforts to curb inflation rates are paying off, even at the cost of decreased economic growth.

Final GDP data for the Euro area showed that the Eurozone economy expanded by only 0.1% in the second quarter of the year against expectations of 0.3% growth. The Eurozone economy barely expanded in the second quarter after contracting by 0.1% in Q1 of 2023. The EU economy is struggling and cannot withstand much further tightening. 

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GBP 

GBP/USD rose to the 1.221 level on Monday as the dollar weakened. If the GBP/USD rate goes up, it may encounter resistance near 1.233, while support may be found near 1.212. 

The British economy continues to struggle, registering only nominal growth. GDP data revealed that Britain’s economy only partially recovered in August after a sharp drop in July. The British economy expanded by 0.2% in August from a 0.6% contraction in July, in line with expectations. 

Quarterly GDP data have shown that the British economy expanded at a higher pace than anticipated, expanding by 0.3% in the first three months of the year. GDP data for the second quarter of the year indicated a 0.2% expansion. More importantly, the UK's economy has grown by 1.8% since the pandemic started, beating the previous estimate of a 0.2% contraction.

The BOE maintained its official rate at 5.25% at its policy meeting in September against expectations of a 25-bp rate hike. The BOE has also signaled that it has likely reached its peak interest rate. 

BOE Governor Andrew Bailey has stated that the central bank would be watching closely to see if further rate hikes are needed. Bailey also emphasized that the BOE will be holding interest rates in restrictive territory long enough to see inflation down to the bank’s 2% target.

British Inflation cooled more than expected in August, demonstrating the effectiveness of the BOE’s consistently hawkish policy. Headline inflation dropped to 6.7% year-on-year in August from 6.8% in July against expectations of 7.0%. 

A combination of a struggling economy and high inflation is making the BOE’s task more difficult. Further tightening is needed to bring inflation down at the risk of tipping the British economy into recession. The state of the British economy remains fragile, as prolonged tightening has taken its toll on the labor market and other vital economic sectors. 

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JPY

USD/JPY traded sideways on Monday, oscillating near the 149.5 level. If the USD/JPY pair declines, it may find support near 148.2. If the pair climbs, it may find resistance at 150.

The Japanese government intervened recently to support the Yen as USD/JPY rose briefly above the 150 level, which is considered a line in the sand for an intervention. The Yen continued to retreat after a brief respite, and the USD/JPY rate moved precariously close to the key 150 level again last week.

Japanese authorities have been repeatedly warning speculators against excessive short selling of the Yen and have stepped in before to provide support for the Yen. On Friday, Japan's top currency diplomat Masato Kanda stated that the government will take appropriate action against a backdrop of excessive moves in the yen when needed.

The effect of such an intervention, however, is usually short-lived and cannot be sustained for long before the USD/JPY resumes its bullish momentum. The main goal of the Japanese government is to discourage speculators from excessive short-selling of the Yen.

The BOJ has maintained its dovish bias, putting more pressure on the Yen as other major central banks, and especially the Fed, have been moving in a hawkish direction for over a year. At its policy meeting in September, the BOJ maintained its short-term interest rate target steady at -0.10% and showed no signs of relaxing its ultra-easy policy.

Market odds of a BOJ rate hike in January have increased above 60%. BOJ Governor Kazuo Ueda has hinted that a policy shift may finally be on the horizon. 

National Core CPI dropped to 3.1% in July from 3.3% in June. Inflation in Japan has remained above the BOJ’s 2% target for more than a year, encouraging the BOJ to tighten its monetary policy. BOJ Core CPI climbed to 3.3% on an annual level in August beating expectations of 3.2%. 

Final GDP data for the second quarter of the year showed that the Japanese economy expanded by 1.2%, disappointing expectations of 1.4% growth. The final GDP Price Index showed a 3.5% annual expansion, versus 3.4% the previous quarter. Japan’s economic recovery increases the odds of a hawkish pivot in BOJ’s monetary policy.

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Written by:
Myrsini Giannouli

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