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USD: Fed signals higher rates for longer & softer landing for US economy.
During the Asian trading session, the US dollar has maintained its strength following the recent FOMC meeting. This resulted in the dollar index reaching an intraday high of 105.69. The surge in the US dollar's value has been driven by the upward adjustment in US yields overnight. Specifically, the 2-year US Treasury yield saw a notable increase of approximately 12 basis points since just before the FOMC meeting, reaching an overnight intraday high of 5.18%. This represents a new cyclical high, surpassing the previous high of 5.12% from July.
The rise in short-term yields also had a mild effect on longer-term yields. The 10-year US Treasury yield increased by around 10 basis points, reaching a new cyclical high of 4.45%. This shift in yields was primarily triggered by the Federal Reserve's decision to adopt a more hawkish stance yesterday morning at 4am on Sydney time. While the Fed opted to keep the policy rate unchanged, the updated guidance provided a clear indication that the Fed intends to maintain higher interest rates for an extended period (hawkish stance). Consequently, the US rate market has scaled back its expectations for rate cuts by the Fed in the upcoming year, with approximately 58 basis points of cuts now being priced in by the end of the next year. This month alone, nearly 50 basis points of cuts have been removed from the US yield curve, lending further support to the US dollar.
The Fed's "higher for longer" message was articulated through revisions to economic and policy rate projections. The updated dot plot revealed that a majority of FOMC participants still plan to implement one final rate hike later this year. Out of the 19 participants, 12 favour increasing the policy rate to 5.625% by year-end, mirroring projections from June. The most significant alteration to the forecasts is that FOMC participants now anticipate fewer rate cuts in the coming years. The median projection for the Fed's policy rate by the end of the next year and the end of 2025 has both been raised by 0.50 point to 5.1% and 3.9%, respectively. Additionally, the Fed released projections for 2026 for the first time, showing a policy rate closer to their neutral estimate of 2.5%, with a projection of 2.9% by the end of 2026.
The primary reason behind the Fed's indication of a prolonged period of higher rates is its increased confidence in a softer landing for the US economy. There were notable upward revisions to GDP forecasts for this year and the next, now standing at 2.1% and 1.5%, respectively. This suggests a more modest slowdown in growth in the coming year. Consequently, the Fed no longer anticipates a significant rise in the unemployment rate from its current level of 3.8%, which is slightly above the cyclical low of 3.4% set in January. The unemployment rate forecasts for this year and the next were both revised downward by 0.4 percentage points to 4.1%. With less expected slack in the US labor market, the Fed does not foresee continued undershooting of their inflation projections in the years ahead. While the core PCE forecast for this year was lowered by 0.2 percentage points to 3.7%, core inflation forecasts for the next year and 2025 remained largely unchanged at 2.6% and 2.3%, respectively, with a slight increase of 0.1 point.
Overall, the Fed's updated guidance is expected to reinforce the upward momentum of the US dollar in the short term. There is a higher risk of one final rate hike in November or December, although weaker economic activity and core inflation data in Q4 could dissuade the Fed from following through with these plans. Similarly, we anticipate a more significant negative impact on the US economy in the coming year due to the delayed effects of previous aggressive tightening, which may encourage the Fed to implement more than the planned 50 basis points in rate cuts by the end of 2024.
USD VS. SHORT-TERM YIELD SPREADS
Source: Bloomberg, Macrobond & MUFG Research
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