Dollar Climbs: Have Investors Overdone The Dovish-Fed Trade?

The dollar inched higher on Monday as equity markets took a breather from their recent rally, leaving some investors wondering whether dovish calls on U.S. interest rates were becoming stretched.

The dollar index (DXY), a weighted measure of the dollar’s value against a basket of rival currencies, inched 0.3% higher to 103.57. Although still down from its 2023 peak above 107, the index has endured three-consecutive weeks of losses, working in contrast to equity markets which have soared since the end of October.

“We suspect November’s 3% decline was a bit too much. A bounce could lift it back to the 104.70-105.00 before it falls out of a favor again,” said Marc Chandler, chief forex strategist at Bannockburn Global Forex.

Exchange traded funds that track dollar bullish behavior have moved lower in recent weeks, while those tracking bearish sentiment have increased. On Monday, the Invesco DB US Dollar Index Bullish Fund (NYSE:UUP) was up 0.5%, while the Invesco DB US Dollar Index Bearish Fund (NYSE:UDN) was down 0.3%.

Also Read: Dollar Dumps In November As Fed Rate Cut Optimism Increases

Have Fed Rate Cut Expectations Become Overstretched?

Much of the recent downtrend for the dollar and uptrend for the equity markets has been based around expectations the Federal Reserve will begin cutting interest rates in the first quarter of 2024.

These expectations have been underpinned by falling inflation rates, but not by any rhetoric from the Fed itself.

“Rate cuts in the first half of 2024 are being priced into many economies given the downside recession risks and some more promising data on inflation. We disagree, and think that stickiness in inflation will keep central banks on hold for longer,” said James Pomeroy, economist at HSBC.

Chairman Powell Retains Cautious Tone

Markets were a little jarred on Friday after Fed Chairman Jerome Powell declined to play the dovish card in an interview and, instead, called for restraint in drawing premature conclusions about future policy moves.

“While lower inflation readings of the past few months are welcome, this progress is going to need to continue if we are to reach our 2% objective,” he said.

Powell added that if necessary, the Fed was still prepared to tighten policy rates further.

“Inflation is unlikely to sustain the very low…