USD at a Jun(e)cture – Weekly Briefing

Over the past month, the USD has made a strong comeback, benefiting from several factors. Firstly, May typically provides favorable market conditions for the USD. Secondly, concerns regarding potential issues with the US debt ceiling resolution have diminished, reducing risks for the currency. Lastly, there has been a significant shift in how the market prices the anticipated actions of the Federal Reserve.

Looking ahead, historical trends suggest that the USD tends to relinquish some of its gains from May in the following month. Additionally, most of the positive effects resulting from the US debt limit deal already appear to be factored into the value of the USD. The expected surge in bill issuance is likely to maintain high interest rates while simultaneously reducing the availability of USD liquidity.

As a result, the resolution of the US debt ceiling should enable the Federal Open Market Committee (FOMC) to concentrate solely on macroeconomic factors when determining its monetary policy in mid-June. This puts the Federal Reserve back in control of financial markets. In just a few weeks, there has been a notable shift, with market expectations transitioning from the possibility of interest rate cuts to nearly fully pricing in a 25-basis points rate hike for the upcoming two meetings.

The upcoming macroeconomic data from the United States has the potential to sway the situation in either direction. Specifically, substantial positive surprises in the May US jobs report and CPI data might be necessary to challenge the firmly established and widespread cooling trend. This trend is further supported by recent anecdotal evidence found in the Fed Beige Book.

Based on the current circumstances, US economists maintain the beliefs that the Federal Reserve has reached its peak in interest rates last month. If the Fed decides to pause its rate hikes this month, it is likely that the resurgence of the USD may have already reached its limit. However, the extent of the reversal would depend on the nature of the forward guidance provided by the Fed. In 2019, after the last rate hike, the Fed adopted a "patient" approach in the subsequent meeting. Conversely, in 2006, the option for further rate hikes remained on the table for several months. The latter scenario could result in a more gradual decline of the USD, though still a reversal. If the dot plot or vote split clearly indicates that the Fed will skip a rate hike in June rather than pausing, the USD may retain its gains in the short term.

Regardless, the upcoming meetings of the RBA and the BoC this week are unlikely to serve as ideal models for the Federal Reserve's meeting the following week. The RBA may choose to continue its unexpectedly implemented rate hike from May and maintain a hawkish stance due to factors such as significant migration, a substantial increase in the minimum wage, and anticipated electricity price hikes that may impact inflation. On the other hand, in the absence of new labour and inflation data from Canada before Wednesday, the BoC might extend its conditional pause for a fifth consecutive month.

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