Another Fed Jumbo Hike in Focus as Markets Bet on Policy Moderation

US Dollar Fundamental Forecast: Neutral

• US Dollar weakens as S&P 500 gains, Fed hawkishness bets taper
• Eyes are on another jumbo 75-basis point rate hike on Wednesday
• That will be followed by Friday’s non-farm payrolls likely cooling

The DXY US Dollar index has declined by over 1 percent over the past 2 trading weeks. That was the worst 10-day performance since the middle of July. A couple of reasons could explain the move. The first is an improvement in risk appetite. On Friday, the S&P 500 rose about 2.4%, closing at the highest since late September, denting demand for the haven-linked currency.

This optimism on Wall Street could be explained by an overall solid earnings season so far. The second reason for the dollar’s stumble is a moderation in Federal Reserve hawkish expectations ahead of November’s monetary policy announcement. Looking at the chart below, markets have pulled back projections of a 50-basis point hike in 2023, falling to just a quarter of a percentage move.

The Fed is almost surely going to deliver another jumbo 75-basis point rate hike on Wednesday, bringing rates to 4%. Markets, however, are more interested in what’s after. A 50-basis point rise is priced in for December, followed by 25bps in January. In other words, there are rising expectations of a Fed moderation brewing in financial markets, likely contributing to the S&P 500’s rise and the US Dollar’s drop.

Are markets getting ahead of themselves? The Fed’s preferred gauge of inflation missed expectations for September, with PCE core running at 5.1% y/y versus 5.2% seen. This is still up from 4.9% in August. Meanwhile, the Employment Cost Index crossed the wires at 1.2% for the third quarter, down from 1.3% prior. Despite the growth slowdown, it remains at its most elevated since 2003.

Thus, recent data could go both ways if you are trying to gauge if inflation is slowing. But, this is certainly much better than if both pieces of data beat expectations. As such, the recent performance of the Greenback seems reasonable. What remains uncertain is how Fed policymakers will approach the pace of tightening in the coming months. Do keep in mind that balance sheet reduction is in full swing.

Attention then shifts to Friday’s US non-farm payrolls report. The economy is seen adding 190k jobs in October, down from 263k in September. The unemployment rate may rise to 3.6% from 3.5% as average hourly earnings slow. Such a cooldown in the labor market could reinforce Fed moderation language. This may hurt the US Dollar further. Such a probability will keep the fundamental outlook neutral.

2023 Fed Rate Hike Expectations

Chart Created in TradingView

— Written by Daniel Dubrovsky, Senior Strategist for DailyFX.com

To contact Daniel, follow him on Twitter:@ddubrovskyFX