The dollar is near the extremes of the world’s most popular currencies. The dollar index is near the peaks of March 2020 and January 2017. Investors and traders have pushed the dollar to a vital turning point over the past six years, anticipating one of the most hawkish decisions in decades.
Today’s FOMC decisions will determine whether we see the formation of a DXY triple top and the start of a dollar pullback or whether we see further momentum building with the benefit of dollar buyers.
The FOMC is expected to raise its key rate by 50 points - the sharpest tightening since 2001 - along with the announcement of the start of asset sales from the Fed’s balance sheet at $95bn per month.
Market participants are also laying down a near 100% chance of a 75-point rate hike at the subsequent meeting in June, plus a 50-point in July. Such steep rate hikes were last experienced by the US in the 1980s, battling double-digit inflation.
The Fed’s extreme action is justified and necessary in terms of inflation and current employment data. It is also widely believed that the Fed has been late in tightening and will now need to tighten the screws even further to get the economy back on a sustainable trajectory.
If today’s comments reinforce market expectations that the rate could exceed neutral by the end of the year, the dollar will gain the fundamentals for further strength. On the one hand, a strong dollar will work to reduce inflationary pressures.
But on the other hand, it could cause an economic shock and worsen the conditions for the Fed to sell bonds into the market, putting additional stress on the financial system. For the DXY, in this case, a new growth horizon opens with potential targets near the 2002-2003 peaks at 120 over the next 12-18 months.
However, we cannot rule out that comments from the Fed would be vaguer, which markets initially could see as a dovish stance. In this scenario, the Fed would express its concern about the impact of rates on the economy and soften expectations for future hikes. This has the potential to form a reversal in the dollar, which now has a very hawkish scenario built into its exchange rate.
In a dovish scenario, the DXY risks forming another peak and heading towards the lower end of last year’s range, around 90 by 2023.
