Trade of the Week: Hawkish Fed could send USD index to two-year high

After weeks and months of speculation and volatility, FX markets are primed to react to the US Federal Reserve’s policy clues this week.

The Fed is due to issue its keenly awaited policy statement at 18:00 GMT today with Fed Chair Jerome Powell due to hold a press conference just 30 minutes after.

 

What are markets expecting from the Fed this week?

To be clear, markets are expecting the following actions by the Fed today:

• raise rates by 50-basis points (bps) this week, adding to its 25bps hike in March.
   
• announce the exact date for when it will start reducing its balance sheet, which now stands at almost US$ 9 trillion.

Anything other than the outcomes listed above could send shockwaves across global financial markets, affecting various asset classes including currencies, bonds, stocks, and even gold.

 

Markets already looking beyond this week’s FOMC meeting

Given the forward-looking nature of markets, equally crucial to investors and traders is what the Fed says this week about its policy moves in the months ahead.

In order for the Fed to combat overheating consumer prices, markets are currently expecting three consecutive 50bps hikes, with the first occurring this week.

Such an outsized move – which is double the customary 25bps adjustments – had not been seen since May 2000. According to the Fed funds futures, there’s even a 40% chance that the Fed could trigger a 75bps hike in June!

In other words, markets are forecasting that the Fed will have to stay ultra-aggressive in its quest to cool down skyrocketing inflation.

Recall that back in March, the headline inflation figure (a.k.a consumer price index) rose by 8.5% compared to March 2021 - its fastest pace since December 1981.

READ MORE: Inflation everywhere! What does it mean for markets?

 

Dollar’s sharp ascent fueled by markets’ hawkish bets

Note how such hawkish bets in the markets have already spurred the benchmark dollar index (DXY) to its highest levels since December 2002, with DXY treading water just shy of the psychologically-important 104 mark at the time of writing.

 

And the US dollar’s ascent has not spared most of the rest of the FX world, with the greenback boasting of a year-to-date climb against all G10 and Asian currencies (although the currencies of some emerging and frontier economies can still lay claim to a year-to-date advance against the US dollar, for now).

Consider also how the equally-weighted USD Index has surged to its highest level since the early months of the pandemic, now tantalizingly close to the psychologically-important 1.170 mark. Note that this index measures the US dollar’s performance against these six currencies, all in equal weights:

• Euro
• British Pound
• Canadian Dollar
• Australian dollar
• New Zealand dollar
• Swiss Franc

 

How might the US dollar react to the Fed this week?

If the Fed does signal that policymakers indeed have to front-load these larger-than-usual rate hikes in order to try and tame red-hot inflation, that could spur further gains in the US dollar.

These types of policy signals should coax dollar bulls into sending DXY past 104 and for the USD Index to retest the 1.17531 peak from June 2020 as the immediate resistance level. Such a scenario, in turn, should heap more downward pressure on other major currencies.

However, if the Fed surprisingly pushes back on the hawkish bets in the markets, saying that the central bank instead prefers to take rate hikes at a more gradual pace of “just” 25bps at a time, that could see the US dollar unwinding some of its recent gains.

Such dovish policy signals could see DXY retesting the previous cycle high at 101 for support, and for the equally-weighted USD index to move back closer to its January 2022 peak below 1.140. Such a scenario could spell some measure of relief for the rest of the FX universe, although likely in limited amounts and perhaps only temporarily, given that US interest rates are only headed one way, which is up.

It’s now just a question of how quickly and to what extent the Fed deems it appropriate to have reached its inflation goals, crucial answers to which are likely forthcoming in just a few hours from now.

READ MORE: 3 reasons why the US dollar is climbing