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USD: Elevated Fed Policy and Trump Re-election Prospects
The US dollar has been staying at weaker levels lately, with the dollar index staying just above its 200-day moving average around 104.40. Like the dollar index, US yields hit a low on May 16th but have since started to rise, giving the dollar a boost. As a result, the 10-year US Treasury yield and the USD/JPY exchange rate have gone above 4.60% and 157.00, respectively. The entire US yield curve has increased by about 30 basis points since mid-May, due to lower expectations for Fed rate cuts.
USD Index Daily Chart
The market now thinks the Fed will only cut rates once later this year. Currently, only 13 basis points of rate cuts are expected by September, and 32 basis points by December. This suggests that traders expect a hawkish message from the Fed at the next FOMC meeting on June 12th, with possible higher inflation forecasts and fewer rate cuts planned.
Despite what the market thinks, the Fed is unlikely to change its stance significantly. Today's release of the second estimate of US GDP growth for Q1 is expected to show a sharp slowdown, with growth close to 1.0%, down from an average of 4.2% in the second half of last year. However, this slowdown is not expected to ease the Fed's worries about inflation. The Atlanta Fed’s GDP tracker predicts a rebound in Q2, indicating that the weaker Q1 growth is not the start of a prolonged slowdown.
Political developments are also affecting the US dollar. The chances of Donald Trump getting re-elected have increased significantly, from 43% in April to 53% recently, according to PredictIt.com. In contrast, President Biden's re-election chances have dropped from 55% to 44%. If this trend continues, it could strengthen the US dollar further, driven by expectations of more trade disruptions and looser fiscal policy under a potential second Trump term, despite his reported preference for a weaker dollar to boost US competitiveness.
EUR: Inflation Data and ECB Rate Cut Plans
The broad rebound of the US dollar has caused EUR/USD to drop below 1.0800, nearing support at the 200-day moving average around 1.0790. The euro didn't benefit from stronger-than-expected inflation data from Germany in May, which showed a rise in the annual harmonized inflation rate to 2.8% from 2.3% in April. Despite this, core inflation stayed stable at 3.0%.
The rise in headline inflation was driven by the service sector and positive base effects from last year's introduction of a subsidized transport ticket in Germany. There was also a significant rebound in package holiday prices. Today's euro-zone CPI report for May is expected to show a modest increase in headline inflation to 2.5%, with core inflation stable at 2.7%.
The increase in euro-zone headline inflation is expected to be temporary and does not change the outlook for inflation to decline towards the ECB’s target. ECB officials have clearly indicated plans to start cutting rates in June, with Banque de France Governor Villeroy de Galhau confirming that a June rate cut is likely. However, the path beyond the first cut remains uncertain. Some hawkish ECB officials oppose a follow-up rate cut in July.
Recent stronger-than-expected wage growth in the euro-zone for Q1 has led to a scaling back of further ECB rate cut expectations for the year, although this figure was influenced by one-off payments in Germany. The euro-zone rate market currently prices around 58 basis points of ECB cuts by year-end. Despite expectations for three ECB rate cuts this year, the scaling back of these expectations, along with evidence of stronger economic momentum in the euro-zone, supports the euro in the near term.
The euro is at a critical technical point against both the US dollar and the pound. EUR/GBP is testing support at 0.8500, a level that has held for nearly a year, and EUR/USD has fallen back to support around 1.0790. If these support levels are broken ahead of the ECB’s policy meeting on June 6th, further euro weakness is possible.
Insights Inspired by MUFG: Credit to Their Analysis for Shaping Some Aspects of This Text
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