29.05.202315:22 Forex Analysis & Reviews: USD surges amid Fed's hawkish hints and optimism over US debt ceiling deal

A confident start of the US currency at the beginning of the week was facilitated by the Fed's actions aimed at further monetary tightening, as well as the upcoming deal on the US debt ceiling. A shift in debt ceiling talks took place at the end of last week, serving as an additional driver for the dollar.

At the end of last week, the greenback was rising amid expectations of a further increase in the Fed's key rate and an early resolution of the issue related to the US national debt ceiling. The latest event happened last Saturday, May 27, when US President Joe Biden and Kevin McCarthy, Speaker of the US House of Representatives, came to a final decision on the debt ceiling. After the publication of the bill, the American leader announced that default was avoided.

According to the document, in the next two years, the US national debt ceiling will be raised by $4 trillion. According to the bill, government spending for 2024 will be frozen. Earlier, the US Democratic Party proposed such a solution, but the Republicans were against it and insisted on their reduction. However, according to Associated Press (AP) analysts, this agreement may "not suit both Democrats and Republicans because of the many concessions."

The new agreement on the US national debt ceiling will not affect defense spending, which will reach a record $900 billion in 2024. The current bill provides for an increase in the national debt ceiling until 2025. According to AP, the core of the deal is a two-year budget agreement, which involves maintaining government spending at the same level with the possibility of increasing them for defense purposes. In 2025, the level of government spending will increase by 1%, the document emphasizes.

According to Joe Biden, this deal is the most important compromise, thanks to which it was possible to "prevent a possible catastrophic default in the country." According to analysts, delay in this matter could set off a negative chain reaction in the US economy, which would provoke a recession and "loss of millions of jobs."

Currency strategists at Goldman Sachs believe that if the deal is approved by the US Congress before June 5, the country is guaranteed to avoid default, and federal spending cuts will reduce US GDP in 2024 by only 0.1%.

Against this backdrop, the US dollar gained new momentum and demonstrated steady growth. Later, the US currency slightly retreated from recent highs amid a decrease in risk appetite in the markets. On May 29, the greenback rose noticeably as sustained inflation fueled further Fed rate hikes, and the debt ceiling deal boosted investor optimism. The EUR/USD pair was last seen hovering near 1.0741, having found ways for the next rise and strengthening its positions.

According to analysts, a rise in the dollar is also supported by expectations that the Fed will maintain the interest rate at the current level of 5.25% per annum. Market participants expect that the rate will remain the highest over the past 15 years. In the past few weeks, traders have almost lost hope for a cut in the Fed's key rate. Moreover, the possibility of another rate increase estimated at 50% has already been priced in by the market. Investors still expect a single rate cut at the end of 2023.

Strong data on the US labor market as well as recent hawkish comments by the Fed representatives testify in favor of the revision of market expectations. Fed policymakers have repeatedly made it clear that the cycle of raising rates is not over yet. In addition, they noted that this year they are not planning to reduce it.

The data on US inflation represented by the PCE price index added fuel to the fire. According to the US Bureau of Economic Analysis, this indicator increased to 4.4% from the previous 4.2% recorded a year ago. This reading exceeded the forecast of 3.9%.

In addition, the annual core PCE price index, preferred by the Fed for assessing inflation, increased to 4.7%. At the same time, analysts predicted growth to 4.6%. According to Natixis, the current state of the economy has contributed to lower productivity growth, and this has "led to a stagflationary equilibrium with high inflation." Natixis notes that this state of affairs is typical for both the United States and European countries.

Lack of growth in the labor market provokes significant labor costs. This contributes to a sharp increase in employment and increases pressure on the labor market, Natixis emphasizes. As a result, stagflation emerges in the economy, which becomes a problem for central banks due to "contradictions between the goal of reducing inflation and stimulating business activity." As a result, both the Fed and the ECB are not really aggressive in the fight against inflation, Natixis notes.

In the current situation, markets are becoming more bullish on the US dollar. According to the data on the US dollar index, traders began to add more long positions after a previous 2-week decline. At the same time, large funds increased USD purchases by 7% over the week, while USD sales decreased significantly. The continuation of this trend contributes to the growth of the US currency, analysts summarize.