The dollar has experienced a particularly challenging session, during which the EUR/USD exchange rate increased by nearly 1%. This notable movement in the currency market was largely driven by an unexpected decline in the US Consumer Price Index (CPI) inflation, which fell contrary to the analysts' expectations. The market had anticipated steady or even rising inflation, but the surprise drop signaled that inflationary pressures might be easing faster than predicted. This decline in inflation weakened the dollar as it reduced the urgency for the Federal Reserve to maintain high interest rates, which typically support a stronger dollar.
Additionally, the recent conference held by the Federal Reserve Chair, Jerome Powell, did not manage to bolster the USD as some might have anticipated. Powell emphasized that, despite updated economic forecasts, the central bank would prioritize current economic data over projections. This stance diverged from the previous narrative suggested by the dot plot, which had indicated a potential rate cut within the year.
This shift in communication from the Fed Chair raised doubts among investors about the certainty of future monetary policy actions, further undermining the dollar’s strength. The evolving narrative could suggest that the EUR/USD exchange rate is preparing for a more robust rebound, as market participants adjust their positions based on the Fed's latest signals.
This week on the foreign exchange market has been akin to a rollercoaster, characterized by significant volatility and swift changes in sentiment. At the beginning of the week, on Monday, investors were heavily influenced by remarkable data from the US labor market, specifically the Non-Farm Payrolls (NFP) report. This report showed stronger-than-expected job growth, which initially led investors to believe that the Federal Reserve would be less likely to start cutting interest rates this year.
As a result, the EUR/USD exchange rate hit new two-month lows, dropping to 1.0720. This decline reflected the market's confidence in the strength of the US economy and the likelihood that the Fed would maintain higher interest rates to combat inflation.
However, the selling pressure on the euro might have extended even further if not for another unexpected development: a lower-than-expected US CPI inflation reading. This reading suggested that the process of disinflation was making more progress than the market had anticipated. When the CPI data was released at 2:30 PM, the dollar sharply dropped, and the EUR/USD rate surged, reaching as high as 1.085 at one point. This reaction highlighted the sensitivity of the currency markets to inflation data, as lower inflation reduces the likelihood of aggressive interest rate hikes by the Federal Reserve.
Another significant turning point came with the Federal Open Market Committee (FOMC) decision and the release of updated economic forecasts. The Fed decided to keep interest rates unchanged at a range of 5.25% to 5.50%, the highest level in 23 years. This decision was in line with analysts' expectations. However, the updated economic forecasts provided by the Fed painted a different picture. The Fed revised its inflation forecasts for 2024 and 2025 upwards, suggesting that inflationary pressures might persist longer than previously thought.
Despite this, the Fed's new projections only included one 25-basis-point rate cut in 2024, a significant change from the three 25-basis-point cuts forecasted in the March projection. This substantial shift in the Fed's outlook on future rate cuts reflects a more cautious and potentially prolonged approach to achieving their inflation targets.
Despite the Fed's seemingly hawkish stance, the dollar continued to lose value. This apparent contradiction puzzled many market participants. The key to understanding this lies in the statements made by Jerome Powell during his press conference. Powell described the inflation projections as conservative and indicated that the Fed now sees a slightly higher inflation rate for this year, with the Personal Consumption Expenditures (PCE) index projected at 2.6% instead of 2.4%, and the core PCE at 2.8% instead of 2.6%.
These adjustments suggest that the Fed acknowledges the persistent inflationary pressures but remains cautious in its approach. Powell also noted that the inflation expectations for the next year had increased slightly but still expected to hit their target by 2026. This acknowledgment of persistent inflation, combined with Powell's emphasis on current economic data over projections, introduced uncertainty about the timing and extent of future rate cuts.
Therefore, if inflation continues to behave as it did in May, with further negative impacts from fuel prices anticipated for June, the likelihood of a rate cut increases. However, there is a considerable gap between the July and September Fed meetings. During the July meeting, the Fed would need to signal its openness to a rate cut inSeptember. Powell suggested that under favorable conditions, such a scenario could materialize, but it remains highly dependent on the upcoming economic data.
For the market, a slightly more hawkish Fed could actually be beneficial. A softer approach from the Fed could act as a driving force for Wall Street, precious metals, and other risk assets while being a negative factor for the dollar. Powell stressed that the most critical factor remains the current economic readings.
If inflation continues its downward trend, this could lead to a substantial dollar sell-off in the coming months and a revision of expectations regarding the timing and extent of rate cuts in the US. This dynamic interplay between inflation data, Fed policy, and market expectations will continue to be a crucial driver of currency movements in the foreseeable future.
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13.06.2024
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