FED to pause this week

Softer USD is anticipating that Fed will slow pace of hikes.

USD: Will the Fed rock the boat in the week ahead?

The forex market had a calm start to the week but still a very busy week ahead, anticipating policy updates from the Fed (Wed), ECB (Thurs), and BoJ (Fri) in the upcoming days.

The US dollar slightly retreated before the approaching FOMC meeting. Having reached 104.70 at the end of the previous month, the dollar index has since declined towards the 103.00 level. In this month, the US dollar has weakened against all G10 currencies, except the yen.

Notably, commodity related G10 currencies, such as the Australian dollar (+3.7%), Norwegian krone (+3.00%), Canadian dollar (+1.7%), and New Zealand dollar (+1.6%), have outperformed the rest. These currencies benefited from a relief rebound in commodity prices following the significant sell-off in April and May. Bloomberg's commodity price index has risen approximately 3.5% from its year-to-date low at the end of May. Additionally, improving global investor risk sentiment has supported commodity-related currencies.

MSCI's global equity index has regained upward momentum in early June, reaching its highest level since May 2022. This positive trend has also led to a decrease in foreign exchange market volatility. According to Bloomberg, JPMorgan's Global FX Volatility Index has dropped to its lowest level since the beginning of 2022, just before the Ukraine crisis. As a result, FX carry trades have become even more appealing. Popular carry trades, such as USD/BRL, USD/COP, and USD/MXN, all reached their lowest points of the year at the end of the previous week.

The upcoming Fed policy meeting will play a crucial role in determining the prospects of high beta currencies in the coming week. Recently, US yields and the US dollar have lost some upward momentum due, in part, to expectations that the Fed will slow the pace of interest rate hikes this week. Currently, the US rate market is pricing in approximately 7 basis points of hikes for this week's policy meeting and around 21 basis points by the July FOMC meeting.

Historically, the Fed tends to meet market expectations, and they have not sent any hawkish signals in the past week to adjust market expectations. This suggests that they are currently comfortable with a pause in rate hikes. The release of the latest US CPI report for May, just ahead of the FOMC meeting on Wednesday, will be the final test. Unless there is a significant upside surprise in core inflation measures, I anticipate the Fed to keep rates on hold this week but signal that it is not the end of the tightening cycle, leaving the possibility of another hike in July, in other words a hawkish pause same as the RBA has done. This stance should help mitigate further downside for the US dollar. However, another hike that compels the US rate market to price in a higher peak for the tightening cycle, beyond 5.50%, could trigger a temporary shakeout of popular carry trade positions.

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