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US Dollar Forecast: Inflation Data May Revive Rally but SVB Meltdown Poses Risks

US Dollar Forecast: Inflation Data May Revive Rally but SVB Meltdown Poses Risks

Diego Colman, Contributing Strategist

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US DOLLAR OUTLOOK:

  • The U.S. dollar, as measured by the DXY index, finish the week lower as U.S. Treasury rates take a turn to the downside
  • Bond yields plunge despite solid U.S. labor market data, with the move likely tied to concerns emanating from the financial sector following the collapse of SVB
  • All eyes on the U.S. inflation report next week. Bias is for an upside surprise
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The U.S. dollar, as measured by the DXY index was on track for a positive week following Powell’s hawkish comments on Tuesday and Wednesday, but a steep decline in Treasury rates on Thursday and Friday turned the tables, leading the currency benchmark to give up gains and end about flat in the five-session span.

Heading into the weekend, government bond yields dropped like a rock, plunging the most since 2008, as traders repriced lower the Fed’s hiking path despite the solid February U.S. employment results. For context, the U.S. economy added 311,000 jobs in February, well above consensus estimates, but average hourly earnings were slightly weaker than anticipated, clocking in at 0.2% m-o-m and 4.6% y-o-y, a tenth of a percent below Wall Street forecasts.

Softening wage growth is encouraging, but this metric has been very volatile and subject the frequent revisions in recent months, signaling that it may not be reliable as a turnaround signal or as an indicator of less tightness in the labor market. So why have expectations about the monetary policy outlook shifted in a more dovish direction over the past 48 hours, as shown in the chart below, which points to an FOMC terminal rate of 5.28 % versus 5.70% on Wednesday?

2023 FED FUNDS FUTURES IMPLIED YIELD

Chart, line chart, histogram  Description automatically generated

Source: TradingView

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Recent bond market dynamics may be related to banking sector stress sparked by the Silicon Valley Bank (SVB) meltdown. The collapse of this institution, which was shut down on Friday by regulators to protect depositors, has increased fears of broad financial contagion, bringing to the surface hidden risks in the industry and its vulnerability to the current environment of rapidly rising borrowing costs.

Although liquidity concerns have been rising in the wake of the FOMC's forceful tightening campaign, most large banks remain well capitalized despite losses in their long-term investment portfolios, suggesting that the SVB's troubles have not yet reached a systemic level. This means that the downward correction in yields may be exaggerated and therefore transitory.

Focusing on next week’s CPI report, the annual headline index is seen downshifting to 6.0% from 6.4%, while the core gauge is forecast to ease to 5.5% from 5.6%. In terms of possible scenarios, softer-than-anticipated data could ease wagers on a half-point FOMC rate rise in March, tilting expectations more firmly in favor of a quarter-point hike. On the flip side, hotter-than-forecast results could set the stage for faster monetary tightening, leading to a higher terminal rate. The latter case appears more plausible at this time.

As for the US dollar, its recent decline may be short-lived. If rates reprice higher again on the back of hot data, the greenback is likely to resume its recovery in short order. If turbulence intensifies, risk aversion and the flight to safety may be a source of support. Only if the Fed blinks will the U.S. dollar weaken on a sustained basis, but recent comments from Chairman Powell suggest that policymakers have no intention of letting up just yet.

Written by Diego Colman, Contributing Strategist

DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.

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