USD: Bullish Momentum Expected to Continue Amidst Counteracting Forces

Fundamental Analysis of the USD

Saturday, 25 May 2024 Week 21: This report provides a comprehensive analysis of the USD, incorporating data from official government sources like the Bureau of Economic Analysis (BEA), the U.S. Bureau of Labor Statistics, the Federal Open Market Committee (FOMC), and Trading Economics. It analyses geopolitical risks, fiscal policy, economic indicators, and monetary policy to provide a five-week outlook for the USD, intended for Forex traders.

The USD is anticipated to maintain its bullish momentum over the next five weeks, driven by safe-haven demand amidst global uncertainty and expectations of a delayed Fed rate cut cycle. The DXY is projected to trade within a range of 104.50 to 106.50, indicating a potential for further strengthening. This outlook aligns with Trading Economics' forecast of a continued upward trajectory for the DXY.

GEOPOLITICS and RISK TOLERANCE IN U.S. MARKETS

Geopolitical events are contributing to a risk-off sentiment, potentially benefiting the USD as a safe-haven currency. The ongoing war between Israel and Hamas is increasing Middle East tensions, potentially impacting global risk sentiment and oil prices. Additionally, the inauguration of Taiwan's new president is expected to escalate US-China tensions, further fuelling risk aversion in global markets. The USD is also finding support from the shifting expectations regarding Fed rate cuts. The market has scaled back its expectations for an immediate rate cut, with the probability of a September cut falling from 75% to 55%. This shift, fuelled by stronger-than-expected US economic data, is bolstering the USD. Conversely, the UK's upcoming snap election is contributing to political risk and volatility in GBP, indirectly supporting the USD.

U.S. FISCAL POLICY

The FY 2025 Budget presents a mixed outlook for the USD. While the proposed $3 trillion deficit reduction over the next decade could strengthen the currency, the plan's significant spending increases, particularly in healthcare, education, and infrastructure, may exert downward pressure due to potential inflationary effects and increased borrowing. The budget's impact on trade policy, with its focus on domestic manufacturing, remains to be seen. Currently, the US Government Debt to GDP ratio stands at 122.30%, slightly below the forecasted 124.30%. However, projections indicate a continued rise in this ratio, reaching 124.30% by the end of 2024 and 127.80% by 2026, potentially raising concerns about long-term fiscal sustainability and negatively impacting the USD.

U.S. ECONOMY

Despite signs of moderation, recent economic data suggests continued resilience, supporting the USD. While Q1 2024 GDP growth slowed to 1.6%, falling short of the anticipated 2.5%, the housing market demonstrated strength with a 13.9% surge in residential investment. The labour market exhibited mixed signals in April, with the unemployment rate unexpectedly rising to 3.9% despite a 175,000 increase in nonfarm payrolls. This, coupled with average hourly earnings growth slowing to 3.9%, suggests a cooling labour market and easing wage pressures. Inflation data for April indicated moderating price pressures, with CPI at 3.4% and core CPI at a three-year low of 3.6%. The US trade deficit remained near 10-month highs in March, potentially weighing on the USD in the long run.

MONETARY POLICY

The Fed's commitment to containing inflation remains a key driver for the USD. The FOMC's decision to maintain the target range for the federal funds rate at 5.25%-5.50% for the sixth consecutive time, coupled with the reduction in the pace of balance sheet runoff starting June 1st, indicates a cautious approach to monetary policy. The FOMC minutes highlight concerns about persistent inflation and the need for greater confidence in its trajectory before easing policy. This hawkish stance, reiterated by Chair Powell, is expected to support the USD in the near term, particularly given the recent surge in inflation readings.

CONCLUSION

The USD is well-positioned for continued strength over the coming five weeks. The current geopolitical landscape, the Fed's commitment to controlling inflation, and the relative resilience of the US economy are all contributing to a favourable outlook for the USD. However, the substantial increase in government spending outlined in the FY 2025 Budget and the persistently high Debt to GDP ratio pose potential risks to the USD's long-term trajectory. These counteracting forces necessitate careful monitoring by forex traders to accurately assess the USD's future performance.