Dollar surges ahead of Fed meeting

Important calendar events

• JPY: Unemployment Rate
• EUR: French, Italian, German, and Spanish GDP, German Import Prices, Spanish Flash CPI, Preliminary Flash GDP
• GBP: BRC Shop Price Index, M4 Money Supply, Mortgage Approvals, Net Lending to Individuals
• USD: S&P/CS Composite-20 HPI, HPI, CB Consumer Confidence, JOLTS Job Openings

USD

The dollar gained strength on Monday, with the dollar index touching the 103.8 level. US treasury yields edged lower, however, with the US 10-year bond yielding approximately 4.08%. 

This week all eyes will be on the US Federal Reserve and the monetary policy decision on the 31st. The Fed kept interest rates unchanged at its December meeting, within a target range of 5.25% to 5.50%. The US central bank is expected to leave interest rates unchanged again this week. 

Fed Chair Jerome Powell’s press conference after the meeting will attract much attention as traders will focus on the central bank’s forward guidance. Market expectations of future rate cuts fluctuate wildly and are one of the primary drivers of the dollar.

Markets are pricing in a dovish shift in the Fed’s policy as soon as March with over 50% probability. Most analysts, however, predict that the central bank will hold off interest rate cuts until May.

If the Fed removes the tightening bias from its policy statement, markets will interpret this as a sign that the central bank is ready to pivot, which will weaken the dollar. If, on the other hand, the central bank retains a hawkish stance, we expect to see the US dollar and treasury yields go up.

Core PCE price index rose by 0.2% in December according to data released on Friday, which was in line with expectations. Core PCE price index dropped to 2.9% year-on-year in December from a 3.2% print in November. This is the Federal Reserve’s preferred inflation gauge, and a lower print indicates that price pressures in the US are easing.

Advance GDP for the final quarter of 2023 showed that the US economy expanded by 3.3% against the expectation of a more modest 2.0% growth. The US economy is expanding at a slower pace, as final GDP data have shown expansion by 4.9% in the third quarter of 2023, but economic growth in Q4 of 2023 exceeded expectations. Advance GDP Price Index for the final quarter of 2023 came in at 1.5% against expectations of 2.3% and a final print of 3.3% in the previous quarter. This is an indicator of inflation, and a lower print indicates cooling price pressures in the US.

Headline inflation rose by 3.4% year-on-year in December from a 3.1% print in November against the expectation of a 3.2% raise. Monthly CPI rose by 0.3% in December, exceeding expectations of a 0.2% print. Core CPI, which excludes food and energy, rose by 0.3%, in line with expectations. Inflation in the US remains sticky and may put pressure on the Fed to keep interest rates at high levels for longer. 

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EUR 

EUR/USD edged lower on Monday, dropping below the 1.080 level in early trading but pared some losses later in the day. If the EUR/USD pair declines, it may find support at 1.072, while resistance may be encountered near 1.095.

The ECB kept interest rates unchanged at 4.50% as expected at its January meeting. The ECB press conference following the conclusion of the meeting did not hold many clues on the central bank’s policy direction. ECB President Christine Lagarde stated that interest rates are currently at sufficiently high levels to bring inflation down to the central bank’s 2% target over time. Lagarde also reiterated that ECB interest rates will remain at sufficiently restrictive levels for as long as necessary. 

Markets are pricing in rate cuts this year, although ECB policymakers are concerned about persistent inflationary pressures in the Eurozone. The ECB is expected to pivot to a more dovish policy later this year, but the timeline is still uncertain. Markets anticipate rate cuts of around 140 bps in 2024. Odds of ECB rate cuts starting in April are rising, and markets are pricing 50bp of rate cuts by June.

Final EU CPI data for December showed that Eurozone inflation remains sticky, indicating that the ECB still has some ground to cover to ensure that inflation drops sustainably. EU Final CPI for December came at 2.9% year-on-year from 2.4% in November. Core Flash CPI for December dropped to 3.4% from a 3.6% print in November, which was in line with expectations.

The economic outlook of the Eurozone is deteriorating and may force the ECB to pivot to a more dovish policy. The Eurozone economy does not show signs of recovery and is on the brink of recession. Revised GDP for the Euro area showed that the Eurozone economy contracted by 0.1% in the third quarter of the year, which was in line with expectations. The Eurozone economy barely expanded in the second quarter by 0.1%, after contracting by 0.1% in Q1 of 2023. Year-on-year the EU economy registered stagnation with GDP flat at 0%. The Eurozone economy is struggling and cannot withstand much further tightening. 

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GBP 

GBP/USD seesawed on Monday, dropping to the 1.266 level in early trading, then climbing back to the 1.270 level later in the day. If the GBP/USD rate goes up, it may encounter resistance near 1.270, while support may be found near 1.260.

The BOE maintained its official rate at 5.25% at its latest policy meeting, which was in line with expectations. The central bank’s outlook remains hawkish, however, with three policy members voting to increase interest rates versus six members voting to maintain current rates. 

BOE Governor Andrew Bailey has kept a hawkish stance, stressing that inflationary pressures in the UK remain high and that further tightening might be required to bring inflation down to the bank’s 2% target. 

The BOE will likely keep interest rates on hold for some time to bring inflation down. Even though the current restrictive policy is hurting economic growth, the BOE has no choice but to continue its battle against inflation.

Market expectations of the BOE’s future direction reflect the need to keep interest rates in restrictive territory for longer, with BOE rate cuts not expected before May. This week the Fed’s policy decision on the 31st is expected to affect the GBP/USD rate considerably. If the Fed shows signs of a dovish pivot earlier than the BOE, the Sterling might gain strength against the dollar.   

Headline inflation rose to 4.0% year-on-year in December from 3.9% in November, against expectations of a 3.8% print. This marked the first rise in consumer inflation in 10 months, increasing the odds the BOE will keep interest rates at high levels for longer. Annual Core CPI, which excludes food and energy, grew at the same pace of 5.1% in December as in November, beating the 4.9% forecast. 

The British economy remains fragile, reinforcing the notion that the BOE has reached its peak interest rates. Monthly GDP rose more than expected in November, however, inspiring more optimism on the UK’s economic outlook. The British economy expanded by 0.3% in November against expectations of a 0.2% growth and 0.3% contraction in October. Final quarterly GDP data revealed that the British economy contracted by 0.1% in the third quarter of 2023, against expectations of stagnation. The British economy expanded by 0.3% in the first quarter of the year and 0.2% in the second quarter. 

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JPY

USD/JPY dipped on Monday, dropping to the 147.5 level. If the USD/JPY pair declines, it may find support near 145.5. If the pair climbs, it may find resistance near 148.8.

The BOJ kept all policy levers unchanged at its January meeting, maintaining its ultra-easy monetary policy. The BOJ has been keeping interest rates at a negative level, putting pressure on the Yen. The BOJ has so far maintained its dovish bias as other major central banks, and especially the Fed, have raised interest rates to high levels. 

BOJ Governor Kazuo Ueda has hinted at a policy shift down the road. Ueda stated that the likelihood of Japan sustainably achieving the bank's 2% inflation target was gradually increasing. Ueda’s comments increased market odds of a hawkish pivot later in the year.  

An immediate policy shift is not expected yet, but markets are pricing in the first BOJ rate hike in April with over 50% probability. A rate hike by June is considered almost certain, with market odds giving over 90% probability of a shift in the BOJ’s monetary policy by June. Only a small rate hike of 10bps is considered likely, which would bring the BOJ’s interest level from negative to zero. 

Inflationary pressures are not sufficiently high in Japan to justify a shift to a more hawkish policy yet. PPI remained flat year-on-year in December, exceeding expectations, however, of a 0.3% decline. National Core CPI data showed that Japanese inflation cooled further in December with headline inflation at 2.3% year-on-year from a 2.5% print in November. Tokyo Core CPI also dropped slightly to 2.1% in December from 2.3% in November. 

Final GDP data for the third quarter of the year showed that Japan's economy contracted by 0.5% in the third quarter against earlier estimates of a 0.5% contraction. The Japanese economy expanded by 1.2% in the second quarter of 2023, showing that the country’s economy is shrinking and is on the brink of recession. Final GDP Price Index showed a 5.3% annual expansion in Q2, versus 3.5% the previous quarter. This is a measure of inflation, which shows that inflationary pressures are rising in Japan, increasing the odds of a hawkish shift in the BOJ’s policy.

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Written by:
Myrsini Giannouli

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