The Federal Reserve of the United States has taken a tough stance regarding inflation, and the traders have promptly adjusted their expectations for future interest rates. At present, the USD forex market is concentrated on just one issue – will the Fed hike the rates at its upcoming September meeting?
Why the Fed has turned hawkish
Federal Reserve Chairman, Kevin Warsh, took the opportunity of his speech at the economic symposium in Jackson Hole to reiterate that the problem of inflation continues to remain. He said that there would be “work to do” if policymakers did not feel comfortable about inflation being on the right path towards the Fed’s target of 2%.
Warsh also argued that current financial conditions are not restrictive enough and that the US labour market remains close to full employment. His message was clear: the Fed is prepared to keep rates higher if inflation does not improve. For more trading insights and market analysis, readers can also visit tradinguides.com
Such a signal has been sufficient for altering market expectations. Prior to the speech, there was only a small likelihood of an interest rate rise in September; however, following the speech, the probability has increased to two-thirds. In this respect, Barclays has also revised its forecasts, projecting a 25-basis point rise in September and December.
In terms of the US dollar foreign exchange market, this news is significant since a higher interest rate in the United States would be beneficial for dollar-denominated assets.
The dollar is gaining ground
The dollar has responded quickly. The U.S. dollar forex market is reacting first to rate expectations. On September 2, the US Dollar Index was around 99.8, close to a two-week high. The index tracks the dollar against a basket of major currencies.
The U.S. dollar forex market has also seen pressure on the euro and yen. EUR/USD was trading near $1.16, while the yen remained weak around 160 per dollar.
The U.S. dollar forex market is also watching Treasury yields closely. While the 10-year yield is trending towards 4.80% and the two-year yield has gone up, as well, in anticipation of a tighter Fed rate path.
There is a very simple chain reaction in the USD forex market here, as higher rates could lead to higher Treasury yields, which then leads to higher dollar demand, which could hurt other currencies.
Oil prices are adding to inflation fears
Dollar strength can also be explained by several factors apart from the Fed. There are geopolitical concerns between the United States and Iran leading to high oil prices, which may result in an upcoming inflation cycle.
The price of Brent crude oil is trading above $95 per barrel. Increased energy prices may translate into higher prices for transportation, manufacturing, and consumers. Inflation control will, therefore, be difficult for the Fed.
In most situations, the United States dollar forex market usually reacts positively to such concerns since the US dollar is considered a safe-haven currency. Geopolitical risk may lead to investors’ preference for the US dollar amid conflicting economic data.
This price action was seen recently in the Indian rupee market. The Indian rupee fell to around 94.97 to the dollar on September 2 owing to the increase in oil prices, Treasuries yield, and interest rate hikes.
What traders are watching next
The US dollar foreign exchange market can experience even greater volatility before the meeting of the Fed scheduled for September 16. Investors will receive a number of important economic reports before that.
The greatest attention will be paid to employment and inflation in the USA. The jobs report for August is expected this week, while the producer price index will be released on September 10 and the consumer price index on September 11.
Poor jobs report may weaken the case for September interest rates increase, while better employment or stubborn inflation may bolster it.
What this means for forex markets
The outlook for the U.S. dollar forex market has changed drastically over a short period of time. Investors were expecting a softer Fed and lower U.S. dollar forex rates until recently. The new signals changed their expectations.
A hawkish Fed can support the dollar in the foreign exchange market, especially when compared to those currencies where central banks have slower movements. USD/JPY still remains the major currency pair, since the Japanese yen is already under the pressure, while EUR/USD may go down due to rising yields of U.S. dollar forex treasury securities.
Nevertheless, the rally cannot last forever. When the data will be worse than expected, investors will become less confident about a rate hike and a softer Fed statement will bring the dollar back to its previous levels very quickly.
Right now, there are three main factors, which are driving the U.S. dollar foreign exchange market – rate expectations, U.S. Treasury yields and geopolitical risks. Until the next important inflation and employment data, investors will remain very attentive to every signal coming from the Fed.
