USD Weakness to Make Headway as Fed Abandons Hawkish Pledge

US dollar weakness is making headway as the Fed abandons its hawkish pledge

After a sharp sell-off late last year and early 2023, the US dollar, according to the DXY index, made a solid recovery in February, buoyed by hotter-than-expected US economic reports, including labor market data and the consumer price index.

Strong business hiring, along with rising inflationary pressures, has led traders to assume that the Federal Reserve will need to raise borrowing costs more aggressively to bring inflation back to the long-term target of 2.0% over the outlook horizon, a view later reinforced by the hawkish position. Bank comment.

In this context, expectations for the final FOMC interest rate rose, reaching 5.7% at its highest point in early March. These boosted Treasury yields across the curve, especially the short-term ones, paving the way for the DXY to rally to its best level of the year, just a touch below the 106.00 handle.

However, the upward movement in yields and the dollar quickly collapsed in response to the banking sector turmoil, which saw two medium-sized banks collapse within two days of each other. While there were private reasons for their failure, the Fed’s fast-and-furious walking cycle also bears some responsibility.

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Chart 1: Implied Return for Federal Reserve Funds Futures, 2-Year and 10-Year Treasury Yields, and the DXY Index

Source: TradingView, Reporting by Diego Coleman

The Federal Reserve adopts a dovish stance amid banking sector turmoil

To protect financial stability, the FOMC adopted a less aggressive stance at its March meeting, backing away from hawkish pledges/rhetoric and laying out roughly the same walking path projected three months earlier in the December Summary of Economic Outlook, despite bullish inflation risks.

The Fed’s dovish stance suggests that policymakers may be convinced interest rates are now at/near sufficiently constraining territory in the wake of recent developments in the banking sector and consider their negative impact on broader credit conditions. This does not mean a full monetary policy pivot, but it is the first step in the direction.

The pivot of monetary policy looms as recession risks grow

With the Fed’s tightening campaign over and traders already gearing up for the first rate cut amid subdued economic activity, the US dollar is likely to face a challenging second quarter against its large peers, especially if sentiment picks up in a material way. This means that more losses may be on the horizon for the dollar.

However, there is one major risk to a downside scenario: more market turmoil. If banking pressure intensifies and leads to some kind of financial crisis, the US dollar may shine and regain leadership in the foreign exchange space thanks to its safe-haven appeal, but this is not the baseline scenario.

Recent events have shown that the Fed, along with other US authorities, will not allow systemic risks to fester and grow, but will step in to prop up the financial system at the first sign of trouble. With this support in place, any bouts of risk aversion and US dollar strength could be short lived.