The market bets on "hawkish rate cuts" as the dollar remains strong ahead of the Federal Reserve's interest rate decision

According to the Zhitong Finance APP, on the eve of the Federal Reserve's highly anticipated third interest rate cut in 2024, the US dollar unexpectedly remained strong. The US dollar index, which measures the strength of the dollar against a basket of currencies, stabilized above 106.8 points during Tuesday's Asian trading session, close to the recent peak it reached. This is mainly because traders have been pricing in that after Trump returns to power next year, his domestic tax cuts and external tariffs will significantly slow down the Fed's rate cuts in 2025, or even halt them for a period of time, thus raising expectations for the neutral interest rate. Additionally, traders are betting that Fed Chairman Jerome Powell will exhibit "hawkish forward guidance" during the press conference following the rate cut announcement. These factors have contributed to the recent significant rise of the dollar against multiple currencies.

The euro, which has appeared "unmoored" this year, has fallen nearly 5% against the dollar, and is not far from the year-to-date low of 1.0518 dollars. Many investment institutions are betting that under the combined effects of the European Central Bank's continued rate cuts, political crises in France and Germany, and Trump's tariff policies, the euro will plummet to parity against the dollar next year, meaning a 1:1 exchange rate.

The gap between the yields of 10-year US and German government bonds is 216 basis points, having widened by nearly 70 basis points in three months. The recent sharp rise in US Treasury yields is also a core logic driving funds towards the dollar.

The yen has been at a disadvantage for seven consecutive trading days, with the exchange rate between the yen and the dollar slightly falling to 154.17 during early Asian trading. This is mainly because the foreign exchange market has significantly reduced the likelihood of the Bank of Japan announcing an interest rate hike this week, believing it is more likely to choose to raise rates again in January or later.

The Federal Reserve will announce its December interest rate decision on Wednesday, Eastern Time, with the interest rate futures market pricing in a 94% probability of a Fed rate cut. However, according to the S&P Global Purchasing Managers' Index survey, service sector activity has surged to a three-year high.

Nevertheless, based on the forward guidance exhibited by several Federal Open Market Committee (FOMC) voting members, the pace of Fed rate cuts in 2025 is expected to slow significantly compared to the current pace. The latest pricing in the interest rate futures market indicates only 2-3 rate cuts in 2025, a significant reduction from the previous expectation of at least 6 cuts before November. This latest expectation also supports the recent upward trend of the dollar index. After the rate cut announcement in December, the interest rate futures market shows that the probability of the Fed cutting rates by only 25 basis points in 2025 or not cutting rates at all is about 37%, compared to less than 20% a week ago.

As Federal Reserve officials enter their quiet period, Nick Timiraos, known as the "new Fed communicator," published an article in The Wall Street Journal on the 16th, stating that investors generally expect a third rate cut this week. Subsequently, Fed officials are preparing to slow down or even temporarily halt rate cuts. Timiraos noted in the article that there is significant internal disagreement within the Fed regarding the continuation of rate cuts Some officials from the hawkish camp are concerned that an early rate cut could keep inflation high and damage the credibility of the Federal Reserve. Additionally, some officials worry that certain policies following Trump's return to power could significantly raise inflation.

BNP Paribas believes that the Federal Reserve will maintain stable interest rates throughout next year, and the bank expects that it may not be until mid-2026 that the rate-cutting process could potentially resume. Other institutions generally expect the Federal Reserve to implement two to three rate cuts of 25 basis points each next year.

The GDPNow indicator from the Atlanta Fed shows that the U.S. GDP growth rate for the fourth quarter could reach as high as 3.3%. Strong economic growth and expectations of a "soft landing" for the U.S. economy have significantly boosted yields and ultimately supported the dollar, compounded by an increasing number of traders believing that the anticipated rate cut this week may be the last in the near term.

Brent Donnelly, president of Spectra Markets, stated, "I think the Federal Reserve is now concerned about inflation rising sharply again, as the unknown second-term MAGA policy mix from Trump and the current price stickiness create multiple pathways for inflation to return in 2025." "Therefore, I believe they will send very cautious signals and tend to use hawkish language that implies concerns about inflation and higher neutral rates to manage market expectations."

In addition to the Federal Reserve, the Bank of Japan, the Bank of England, and the Norges Bank will also hold monetary policy meetings this week. The market generally expects other central banks to keep their benchmark rates unchanged on Thursday, while the Swedish central bank may announce a rate cut of up to 50 basis points.

On Monday, the British pound saw a slight rebound, as business activity surveys indicated rising prices in the UK. The latest labor data for the country will be released on Tuesday, and due to increasing wage pressures, the Bank of England needs to proceed cautiously.

The Canadian dollar fell to its lowest point in four and a half years on Monday, affected by an unexpected cut in the benchmark interest rate and the pressure from U.S. tariff risks. Additionally, the sudden resignation of the country's finance minister, Chrystia Freeland, has put greater pressure on the unpopular Canadian government, making it difficult for the Canadian dollar to shake off its short-term downturn.

Due to the uncertainty surrounding tariff policies brought about by Trump's administration and weak demand in Asia, investment sentiment in the export-dependent economies of Australia and New Zealand has been very low recently, with the Australian dollar and New Zealand dollar consistently pinned near their lowest points of the year. New Zealand has raised its bond issuance forecast for the coming years, and long-term yields may continue to rise, which could help alleviate the downward pressure on the New Zealand dollar