An Important Week for Testing Early Fed Rate Cut Expectations

Will the anticipation of a rate cut by the Federal Reserve increase?

The US dollar exhibited a modest resurgence in the latter part of the previous year, rebounding from an intra-day low of 100.62 on December 28th to reach an intra-day high of 101.59. Despite an uptick in demand towards the year-end, the dollar concluded the calendar year on a downward trajectory, registering a 2.1% decline in the dollar index for 2023. This reversal followed robust gains of 6.4% and 8.2% in 2021 and 2022, respectively.

The primary impetus behind the late-year sell-off of the US dollar was the heightened speculation surrounding the potential for earlier and more pronounced rate cuts by the Federal Reserve. At present, the US rate market is pricing in approximately 24 basis points of cuts by the time of the March 20th FOMC meeting, with a cumulative total of around 155 basis points anticipated for the entire year. The recent dovish recalibration of Fed rate hike expectations has set a higher bar for additional weakness in the US dollar at the outset of this year. Market participants are now eagerly awaiting the release of weak US economic data encompassing both activity and inflation to substantiate expectations of the Fed initiating rate cuts as early as March.

In the upcoming week, market sentiment is poised to be influenced by the release of the latest FOMC minutes from the December 13th meeting and the nonfarm payrolls report for December scheduled for Friday. The dollar index is currently positioned approximately 2.5% lower than its level preceding the last FOMC meeting on December 13th, an event that triggered a substantial sell-off after Fed Chair Powell hinted at preliminary discussions on the duration of rate maintenance before potential cuts. The updated dot plot underscored a planned rate cut, with the majority of FOMC participants expressing a preference for at least three cuts by the end of the year.

Despite concerted efforts by some Fed speakers to temper expectations for an early rate cut, the release of the December FOMC meeting minutes will be scrutinized closely to assess whether the Fed aims to further dampen speculation. Persistent expectations for earlier rate cuts are rooted in supportive US economic data, notably the slowdown in the core PCE deflator in November, instilling confidence that inflation will gravitate towards the Fed's 2.0% target. As the dollar index approaches crucial technical support levels just above 100.00, the prospect of a temporary bounce at the beginning of 2024 is acknowledged. Nevertheless, a broader weakening of the US dollar is anticipated over the course of the year.

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