Another giant Fed hike in the spotlight as markets bet on policy moderation

US Dollar Fundamental Forecast: Neutral

  • US dollar weakens as S&P 500 gains and Fed hawkish bets dwindle
  • All eyes are on another giant 75 basis point rate hike on Wednesday
  • This will be followed by Friday’s likely cooling in non-farm payrolls

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The DXY US Dollar Index is down more than 1% in the past 2 weeks of trading. This is the worst 10-day performance since mid-July. Two reasons could explain the move. The first is an improvement in risk appetite. The S&P 500 rose about 2.4% on Friday, closing at its highest since late September, which weighed on demand for the heaven-linked currency.

This optimism on Wall Street could be explained by a strong earnings season overall so far. The second reason for the dollar’s stumble is a moderation in hawkish expectations from the Federal Reserve ahead of the November monetary policy announcement. Looking at the chart below, markets have pulled back projections of a 50 basis point rally in 2023, falling to just a quarter of a percentage point.

The Fed will almost surely offer another giant rate hike of 75 basis points on Wednesday, taking rates to 4%. Markets, however, are more interested in what’s next. An increase of 50 basis points is expected for December, followed by 25 basis points in January. In other words, there is growing expectation of Fed moderation in financial markets, which will likely contribute to the rise of the S&P 500 and the fall of the US dollar.

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Are the markets getting ahead? The Fed’s preferred inflation gauge missed expectations for September, with core PCE at 5.1% yoy vs. 5.2% observed. That’s still up from 4.9% in August. Meanwhile, the employment cost index crossed the wires to 1.2% for the third quarter, from 1.3% previously. Despite the slowdown in growth, it remains at its highest level since 2003.

So the recent data could go either way if you’re trying to gauge whether inflation is slowing. But it is certainly much better than if both data exceeded expectations. Thus, the greenback’s recent performance seems reasonable. What remains uncertain is how Fed policymakers will approach the pace of tightening in the months ahead. Keep in mind that balance sheet reduction is in full swing.

Attention then turns to Friday’s US non-farm payrolls report. The economy is expected to add 190,000 jobs in October, compared to 263,000 in September. The unemployment rate could rise from 3.5% to 3.6% due to the slowdown in average hourly earnings. Such a slowdown in the labor market could reinforce the Fed’s rhetoric of moderation. This could hurt the US dollar further. Such a probability will keep the fundamental outlook neutral.

Expectations of the Fed’s rate hike in 2023

Chart created in TradingView

— Written by Daniel Dubrovsky, Senior Strategist for DailyFX.com

To contact Daniel, follow him on Twitter:@ddubrovskyFX

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