The Fed has renewed interest in the USD, potentially triggering a market correction

At the end of its regular meeting, the Fed improved economic growth estimates, raised inflation forecasts for this year and brought the expected interest rate hike date closer. These estimates caused the dollar to jump by more than 1%. This is a significant move for the currency market. We have not seen such a sharp intraday DXY growth since March 2020. Market participants were thus surprised by the changes presented by the Fed.

Interestingly, for economists, the actions of the US central bank seem to be lagging, given macroeconomic realities and forecasts. Such lagging helps to reduce market volatility. We recall how markets reacted at the end of 2018 to hawkish signals from the Fed that did not match expectations.

It is quite possible that in stock markets, we could see something of a repeat of the situation of three years ago when the Fed tried to ground the markets’ optimism. The key to this manoeuvre is to maintain control of the situation. As we recall, back then, the decline in markets was to an alarming scale, and eventually, the Fed began to soften policy. If so, we are now only at the starting point of a correction in equity indices.

In case of growing fears before the Fed’s overzealous stimulus rollback, a full-blown correction pullback in the Dow Jones could be in the range of 30-31k points versus a historical peak near 35k in May and values around 33.9k now. Such a pullback should not be attributed to fears of a return of recession, but rather it gave start of winding down excessive optimism.

On the foreign exchange market, the USD index has pushed EURUSD back to 1.2000 and GBPUSD to 1.4000 – psychologically important round levels.

EURUSD, which yesterday morning was clinging to the support of the 50-day average, on Thursday morning is testing 1.2000, where the 200-day average, a significant trend-setting watershed level, lies. A firm dip lower in the week promises to be the most worrisome signal for the euro in the weeks ahead.

There is an important fundamental reason for the weakness of the single currency. A week earlier, the ECB had signalled that it was far from making any policy changes. However, traders apparently preferred to wait for the Fed’s comments to start reassessing rates amid a widening contrast in the sentiment of the major central banks.  Also noteworthy is EURGBP, which has updated to 2-month lows, as ECB softness is still far from being factored into quotations.

The British pound’s pullback is more modest. Yesterday’s sell-off took it to test the 50-day average, but that might just be the beginning of the decline as the GBPUSD is highly correlated to the stock indices.

A stronger dollar, driven by monetary policy (actual or expected), brings bad news for commodity assets, including gold. Following a more than 2% sell-off yesterday, it was right below the 200- and 50-day averages, trying to find some support in the $1800 area on Thursday morning.

The FxPro Analyst Team