US Dollar: Fed repricing risk caps downside – Rabobank

Rabobank’s Senior FX Strategist Jane Foley points out that the US Dollar (USD) has outperformed G10 currencies due to expectations of substantial tightening from the Federal Reserve over the next year. However, she cautions that the USD may experience a decline if the Fed falls short of these expectations. The dollar is the leading performing G10 currency over a five-day period, thanks to the anticipation of a 25 basis point rate hike at today’s policy meeting, with the market pricing in nearly 100 basis points of rate hikes over a year.

This suggests that if the Fed fails to meet market expectations, the USD could weaken. Rabobank’s view is that the market may have overestimated the Fed’s policy tightening, and today’s FOMC meeting could undermine the market’s conviction on future rate hikes. While a reduction in expected Fed rate hikes could make the USD more vulnerable, the greenback still benefits from its status as a net energy exporter and its safe haven appeal, which could continue despite concerns over the US's budget deficit.

The USD is currently near a two-week high, supported by the anticipated Fed rate hike and oil-driven inflation fears, which push up US bond yields to multi-year highs. Additionally, escalating Middle East tensions serve as a safe-haven effect, weighing on the risk-sensitive Australian Dollar (AUD). USD/JPY reaches a new one-week high above 155.00 in the Asian session, buoyed by the bullish US Dollar and rising US bond yields.

Oil-driven inflation fears and the expectation of a Fed rate hike further support the USD's safe-haven status. However, USD/JPY remains below the mid-155.00 level as traders remain cautious ahead of the Fed's decision and the Bank of Japan's meeting, which begins on Thursday. Gold, meanwhile, recovers from two consecutive daily declines, approaching the $4,350 mark, despite a moderate advance in the US Dollar and falling US Treasury yields ahead of the Fed's rate hike.

Japan's ultra-low interest rates have historically made the Yen one of the world's cheapest sources of funding. As the Bank of Japan tightens policy, that advantage may change. While most major economies raised interest rates, Japan remains the world's outlier.