US Dollar Fundamental Forecast: Rally May Fade on Fed Balance Sheet Announcement

The US Dollar DXY Index hit its highest level since 2022 last week, adding to a ferocious rally that has been aided by global growth concerns while the Federal Reserve grows increasingly hawkish relative to its peer institutions. Market-based measures for a 50-basis point Fed rate hike at next weeks FOMC meeting, such as overnight index swaps (OIS) and fed funds futures, have strengthened throughout the past several weeks. There is even chatter of a possible 75 bps hike, although the market seems unconvinced.

That opens the door for a surge in the Greenback if the Fed does deliver a jumbo 75 bps hike. However, the USD may have fully priced in the smaller 50 bps hike, leaving the door open to a “sell the news” event. Still, a pullback may be just that. The chance for a reversal in the Dollars bullish trend is unlikely to occur, given the Fed remains poised to deliver another 50 bps hike in the June FOMC meeting. That leaves the Fed on track to tighten policy at a more aggressive rate than major peers such as the European Central Bank (ECB) and the Reserve Bank of New Zealand (RBNZ).

Moreover, the Fed is likely to announce details on trimming its balance sheet, which ballooned to over USD 9 trillion through the pandemic. The details will be key for financial markets, but the move will more than likely cause a reduction in liquidity in the rates market, which would also pressure the broader market through higher short-term interest rates. The announcement may trigger further risk-off flows amid already growing economic concerns. That would bode well for the Greenback, but given the impressive run-up to this week, it could trigger a short-term pullback.