The greenback is losing ground against its main competitors on Wednesday after continuous growth during the past five trading sessions.
Investors are taking profits in anticipation of the Federal Reserve's verdict on monetary policy.
Most Wall Street analysts predict that the US central bank will raise the cost of borrowing by 50 basis points, to 1.25%, at its two-day meeting, which will end on Wednesday.
At the same time, some analysts are inclined to think that the US central bank may raise the key rate by 75 basis points at once.
The futures market points to a 95% probability of a 75 basis point hike in the federal funds rate, compared with 3.9% a week ago.
Strategists at Barclays, Jefferies, Goldman Sachs and JPMorgan Chase, in particular, are expecting a 75bp rate hike this week.
The last time the FOMC raised the rate by this amount was in 1994. Then the central bank managed to organize a so-called "soft landing".
A certain amount of optimism is now inspired by the fact that the economy, apparently, is still on a stable basis, but the main problem is that trust is collapsing under this basis, InvesTech Research analysts say. They point to several worrying signs, including a drop in the confidence of CEOs of companies, a deterioration in the prospects for small businesses and consumer sentiment.
"There is little doubt that we are moving towards a likely "hard landing" of the economy," the experts said.
"The biggest difference between the current situation and the successful "soft landing" of 1994-1995 is how far the Fed has fallen behind schedule. In fact, the surge in consumer prices caught the central bank by surprise. The Fed was supposed to start gradually raising interest rates at the beginning of last year with the appearance of signs of inflation. Instead, it continued to stimulate the economy, both with interest rates close to zero and through monthly bond purchases," they added.
Back in 1994, the Fed raised interest rates to levels that were much higher than the annual change in consumer prices, CFRA Research strategists note."This time, inflation is growing much faster than interest rates. So this is a completely different situation, and the central bank should act much more aggressively," they believe.
In May, the US central bank made it clear that a half-point rate hike was very likely at the next two meetings. At the same time, Fed Chairman Jerome Powell rejected the idea of raising the rate by 75 basis points, and a number of participants in the May FOMC meeting suggested that the strengthening of pressure on the price may stop.
However, last month consumer prices updated the high of 40 years ago. According to the University of Michigan's June consumer sentiment index, short and long-term inflation expectations continued to rise. According to Moody's Analytics, a typical American household spends about $460 more each month on the same basket of goods and services compared to last year. Since oil prices have already reached a 3-month high, there is no sign of price pressure easing.
All this suggests that the Fed will act even more harshly.
The risk that an aggressive tightening of monetary policy will lead to a recession in the United States has increased significantly, UBS strategists note.
70% of analysts surveyed last week by the Financial Times expect that the American economy will fall into recession in 2023. They believe that the Fed's rapid rate hikes will lead to deeper spending cuts and economic growth.
At the same time, 40% of respondents believe that raising rates to 2.8% this year (which will mean an increase of 50 bps in June, July and September) will not be enough to lower prices. Traders are ahead of events, putting in quotes an increase in the cost of borrowing in the United States by 4% by the middle of next year.
The updated dot chart of the Fed will show how justified these expectations are, which will give investors some idea of the future policy of the central bank.
In addition, the central bank will publish forecasts for economic growth and inflation. Analysts expect an increase in the estimate for the consumer price index along with a decrease in GDP forecasts.
How the dollar will react to the results of the FOMC meeting will depend on whether the central bank chooses to raise the rate by 50 bps or 75 bps.
There are five scenarios:
1. The dovish exodus
This scenario provides for an increase in the rate by 50 bp, to 1.25-1.50%, a commitment to increase the cost of borrowing by a similar amount in July and no further steps. This would serve as a relief for the US stock market and would send the dollar down.
However, this scenario has a low probability, since the recent increase in inflation in the United States should push the Fed to a tougher position in the fight against rising prices.
2. Gradual raising of the bar
In this scenario, the Fed will increase the cost of borrowing by 50 bps, and also undertake to do this in July and September. This will be a moderate strengthening of the hawkish position of the central bank and only a slight lag from reality.
Such an outcome is likely to trigger a drawdown of the greenback and a rally in stocks before the bond sell-off puts the USD back on the strengthening path.
This scenario has a medium high probability.
3. Open doors
In addition to raising rates by 50 bps, the central bank could say that it will do this in July, September and as long as it takes.
In this case, stocks will fall due to growing uncertainty, which will lead to a rise in the dollar as investors rush into safe assets.
Such a scenario has a high probability, since it will signal a greater determination on the part of the Fed to fight inflation.
4. Raising the rate by 75 bps with a dovish bias
In this case, the Fed will abandon its early announcement of a 50 bps rate hike and point to the urgency, referring to recent inflation data.
At the same time, Powell will state that the central bank prefers higher rates now at a lower final rate.
In this case, the initial jump in the US currency will be followed by a decline and relief in the stock market when it hears Powell's speech.
This scenario has an average probability because it would show that the Fed is also taking into account the higher unemployment rate caused by the rate hike.
5. Raising the rate by 75 bps with a promise to do everything possibleSuch a "Volcker moment", named after the chairman of the US central bank, who crushed the national economy in the 1980s to lower prices, would devastate the US stock market and send the dollar up.
This is an extreme scenario, and the probability of such an outcome is extremely low, since it would mean that the Fed completely abandons its mandate in the field of employment and intends to go significantly further than simply reducing its priority.
After taking off to a new two-decade peak around 105.65, the greenback witnessed profit-taking on Wednesday amid a decline in the yield of treasuries. The USD index is currently trading more than 0.3% below its highest level since the end of 2002.
The sell-off in the US bond market has stopped, and key Wall Street indexes are trying to shrug off their recent losses, adding about 1% on average.
"Given the current aggressive market pricing, there is a risk that the FOMC's monetary policy decision will be regarded by investors as insufficiently hawkish, which will lower market interest rates in the US and the dollar after the Fed meeting," CBA strategists said.
However, the pullback of the dollar is likely to be short-lived, since the recovery of global markets looks fragile, and the sale of risky assets may resume at any moment, as well as the growth of the protective US currency.
Waiting for the Fed's verdict turned out to be not so boring for the EUR/USD pair.
It rose above the 1.0500 mark at the beginning of the European session due to reports that the European Central Bank will hold an emergency meeting on Wednesday.
The central bank later announced that due to the continued vulnerability caused by the pandemic, the Board of Governors decided that it would be flexible in reinvesting redeemable bonds in the Emergency Purchase Program (PEPP) portfolio.
Some improvement in market sentiment undermined the demand for a safe dollar, but this did not become a tailwind for the single currency.
It received a blow from the ECB representatives, who signaled concerns about the rapid normalization of monetary policy.
This reminded investors of the growing divergence in the rates of the American and European central banks.
In addition, the statistical data received from the eurozone turned out to be disappointing. Thus, industrial production in the eurozone decreased by 2% in April against the projected decline of 1.1%. At the same time, the negative trade balance of the currency bloc amounted to €32.4 billion compared with a deficit of €16.4 billion in March.
As a result, the EUR/USD pair lost the points gained quite quickly and rolled back.
The nearest support is located at 1.0410, and further – at 1.0380 and 1.0340.
On the other hand, the initial resistance is at 1.0490, followed by 1.0530 and 1.0570.