Rally may fade on Fed balance sheet announcement

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US Dollar Fundamental Forecast: Neutral

  • US Dollar rally could see short-term pullback on FOMC announcement
  • Balance sheet reduction plan and potential 75 basis point hike considered this week
  • The base scenario (50 bps rise) could lead to a pause in the USD rally

The DXY U.S. dollar index hit its highest level since 2022 last week, adding to a fierce rally that has been helped by global growth concerns as the Federal Reserve becomes increasingly hawkish by compared to its counterpart institutions. Market-based measures for a 50 basis point Fed rate hike at next week’s FOMC meeting, such as overnight index swaps (OIS) and currency futures federal funds, have strengthened in recent weeks. There is even talk of a possible rise of 75 basis points, although the market does not seem convinced.

This opens the door for a surge in the greenback if the Fed offers a giant 75 basis point hike. However, the USD may have fully priced in the smaller 50 basis point rally, leaving the door open for a “sell the news” event. Yet a setback may be just that. The possibility of a USD bullish reversal is unlikely, given that the Fed remains on course to offer another 50 basis point hike at the June FOMC meeting. That leaves the Fed on track to tighten policy at a more aggressive pace than key peers such as the European Central Bank (ECB) and Reserve Bank of New Zealand (RBNZ).

Additionally, the Fed is expected to announce details of the reduction in its balance sheet, which has swelled to more than $9 trillion during the pandemic. The details will be critical for financial markets, but this move will more than likely lead to reduced liquidity in the rates market, which would also put pressure on the broader market through short-term interest rates. higher. The announcement could trigger new flows of risk aversion amid already growing economic concerns. This would bode well for the greenback, but given this week’s impressive surge, it could trigger a short-term pullback.

— Written by Thomas Westwater, Analyst for DailyFX.com

To contact Thomas, use the comments section below or @FxWestwater on Twitter

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