U.S. Dollar: Another Rally In The Offing?

The US dollar index (DXY) experienced local pressure this week, retracing from a 20-year high of 105.50 to 103.50. Market participants mostly associate this correction with technical factors, while the fundamental backdrop favors dollar buyers.

Traders continue to assess the current risks to the US economy and the recession probability, which has increased significantly after the Fed's aggressive policy tightening moves. Let us recall that the Federal Reserve has already raised its key interest rate twice this year and is seriously considering another rate hike to curb inflation and prevent the economy from overheating.

More skeptical investors are convinced that such a policy stance of the US regulator will only harm the economy. Analyzing similar Fed actions in the past, it's hard to argue with this assumption. The regulator had 13 monetary tightening cycles since 1945, and 10 of them resulted in a recession. So, there were only three soft landings when the central bank avoided the recession. These statistics indicate a high possibility of an economic downturn this time.

The week's highlight was Central Bank Governor Jerome Powell's comments at The Future of Everything Festival hosted by The Wall Street Journal. Powell said the Fed would like to see "clear and convincing evidence that inflation pressures are abating and inflation is coming down." Only then will the regulator consider turning away from its aggressive path of higher rates.

Powell also confirmed that the Fed is still committed to raising its key interest rate by 50 basis points at its June and July meetings and noted that no one should question the Fed's resolve in combating inflation, even if this entails a rise in unemployment.

Despite traders' concerns about the US economy's prospects, the current US macroeconomic backdrop is more encouraging than disappointing. US retail sales data released on Tuesday showed a 0.9% increase in consumer activity in April, while analysts had expected a 0.7% growth.

Industrial production rose 1.1% in April, well above the forecast of 0.5%. It is worth noting that strong statistics add confidence to the regulator, allowing it to maintain its gradual course of interest rate hikes and balance sheet reduction.

The main question is: how far is the Fed willing to go? It remains to be seen. If inflation does not show a steady decline in the near future, the Federal Reserve may agree to push the federal funds rate to 4% in the next 2-15 months, not to 3%, as previously projected. We recommend holding your long DXY positions with a target between 106.00-107.00 points.