Bullish Bias Intact ahead of FOMC, Hawkish Guidance to Boost DXY

US DOLLAR OUTLOOK: BULLISH

• The U.S. dollar, as measure by the DXY index, rises about 2% for the week, supported by soaring U.S. Treasury rates
• The FOMC meeting will be the highlight of the U.S economic calendar and the main catalyst for price action next week
• The Fed is likely to take a very hawkish stance at its June meeting in light of recent inflation developments, creating a bullish environment for yields and the U.S. dollar

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The U.S. dollar index (DXY) rallied this past week, jumpingalmost 2% and breaking above the 104.00 handle, bolstered by soaring U.S. government rates. Yields have risen sharply in recent days, but the upswing was particularly largeon Friday after May U.S. inflation surprised to the upside, surging 8.6% year-on-year, a fresh cycle high and the hottest reading since 1981. Against this backdrop, the Treasury curve shifted upwards across all tenures, with the 2-year yield topping 3% for the first time since 2008.

Looking ahead to next week, when the Fed monetary policy gathering is the highlight of the economic calendar, the U.S. currency is likely to remain biased to the topside as markets position for the possibility of a much more aggressive tightening cycle in response to unrelenting and broadening price pressures in the U.S. economy.

For context, prior to Friday’s CPI release, Wall Street only discounted a 50 basis points hike for the June FOMC meeting, but now wagers for a 75 bps adjustment are increasing, with traders assigning a 40% probability to the latter scenario just before the weekend, versus 3% on Thursday. If these expectations solidify in the coming sessions, the U.S. dollar should be well positioned to command strength against its G-10 counterparts, especially low yielders. Personally, I am still inclined to believe that policymakers will stick to the 50 bps move so as not to upset the market, but they may issue a very hawkish guidance.

Focusing on the U.S. central bank, traders should keep a close eye on the message/rhetoric, but more importantly, on the quarterly summary of economic projection, which includes the famous dot-plot. That said, PCE forecasts are likely to be revised upward for 2022 and 2023, while GDP projections should see negative revisions for both years, but no recession yet.

In terms of the monetary policy outlook, Fed officials may pencil in a steeper path of interest rate increases for this year in light of recent developments on the inflation front, opening the door to half a percentage point hikes at every remaining meeting for the year. This could be quite bullish for U.S. yields and the greenback, allowing the DXY index to retest its 2022 and possibly head towards new multi-decade highs.

DXY DAILY CHART

DXY Index Chart Prepared Using TradingView

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—Written by Diego Colman, Market Strategist for DailyFX