The Fed is nearing the end of its hiking cycle, with both markets and Fed members in agreement. Today, market participants are almost certain that the Fed will raise interest rates by 25 basis points. The question remains whether there will be further rate hikes or if this is the final one in the current cycle. According to former Fed chief Ben Bernanke, this may be the case.
At the last meeting, Fed members planned for two more rate hikes but decided to pause for the month. Following the highly likely rate hike for this meeting, Powell will probably hint at another pause for September to gain almost two months of data to review before making the next move.
Citi’s economic surprise index for the US has risen rapidly in recent months, indicating that the US economy is performing better than expected despite the rate hikes, quantitative tightening, and banking issues. The services sector is perhaps the main reason for the resilient economy and strong labor market, while the manufacturing sector has been slowing down for some time. The latest PMI data suggests that manufacturing activity is still slowing, but there are some signs of a recovery. As the services sector slows down, the hope is that the manufacturing sector will pick up.
Powell and Fed members still believe in a soft landing for the economy, but a resilient economy also means higher inflation. Inflation has been falling rapidly in the last 12 months, but the downward base effect is now over (please check our latest EURUSD post for details), and commodity prices seem to be picking up as the manufacturing sector shows signs of life, alongside the expectation of China’s stimulus. While strong inflation growth is not expected, it might stay above the Fed’s target for some time. The Fed will not want to tolerate over-target inflation for an extended period because it could trigger higher inflation expectations and become entrenched.
Considering all these factors, the Fed will most likely hike rates by another 25 basis points, signal that more hikes could come if necessary, and point out that the pace of rate increases will slow, implying a possible pause for the September meeting. Depending on the data, this could be the last hike as Bernanke suggested. However, the anticipated rate cuts may still be far off, contrary to the market’s expectation of early 2024 cuts.
If the Fed signals that the hiking cycle is likely over today, which is unlikely, the dollar index could take a hit. On the other hand, if Powell shows signs of commitment to another 25-basis point hike, the dollar index could enjoy a small rally in the coming weeks.
The index has formed a falling wedge formation, which tends to break towards the north. But as long as the upper red line holds, there could be more downward moves in store. 101.30 and 102.80 are the two key resistances for now. If these levels hold, the dollar index might test the Fibonacci 61.8% level of 99.178 once more. A break below could lead the index towards 97 (the current lower line of the wedge formation) in the coming days.
However, a hawkish Fed and Powell can cause a breakout of the wedge and ignite another rally, as EURUSD net long positions are overcrowded and ready for a short squeeze.
