Dollar Consolidates Ahead of Key Federal Reserve Meeting

The U.S. dollar edged lower in early European trade Wednesday, consolidating near a 20-year high ahead of the conclusion of the Federal Reserve’s two-day policy meeting which is expected to result in more aggressive monetary tightening.

At 3:05 AM ET (0705 GMT), the Dollar Index, which tracks the greenback against a basket of six other currencies, traded 0.4% lower at 104.880, having climbed to 105.65 on Tuesday, its strongest since late 2002.

The Fed signaled at its meeting in May that half-point increases were very likely at its following two meetings, but expectations have been rising in the wake of Friday’s red-hot U.S. consumer inflation report that it will act even more aggressively this week, and raise its benchmark rate by at least three-quarters of one point.

Market pricing indicates a 95% chance of a 75 basis point rate hike, according to the CME’s Fedwatch tool, up from only 3.9% a week ago.

“My two cents worth is that the Fed will not go 100bps, as that would further erode their credibility on the forward guidance front, which is already ragged,” said Jeffrey Halley, an analyst at OANDA.

“They may, however, decide to upgrade their forward guidance to an even more hawkish tilt. I suspect 75bps is already built into prices now, and if the guidance is more modest in scope, I am sure the buy-the-dippers will be out in force for the rest of the week.”

EUR/USD rose 0.5% to 1.0470, rebounding from the one-month low seen overnight after it was announced that the European Central Bank’s Governing Council will hold a meeting later Wednesday “to discuss current market conditions.”

This meeting comes after the spreads between the yields of Germany and more indebted southern nations, particularly Italy, soared to its highest in over two years in the wake of the ECB’s announcement that it intends to start lifting interest rates in July.

USD/JPY fell 0.6% to 134.66, with the yen making something of a recovery after the pair soared to a fresh 24-year low of 135.58 in early trade.

Helping the yen has been the drifting lower of U.S. Treasury yields, with 10-year yields dipping to 3.40% from Tuesday’s peak of 3.498%, while the two-year yields stood at 3.34%, after touching the highest since 2007 at 3.456% overnight.

The Bank of Japan holds its latest policy meeting on Friday, and faces a dilemma of trying to support its currency while trying to boost a struggling economy.

“A 100bps hike [by the Fed] tonight, and/or a very hawkish outlook, will lift USD/JPY once again and may force the BOJ into lifting the 10-year JGB yield cap slightly,” added Halley.

GBP/USD rose 0.2% to 1.2015, with the Bank of England expected to deliver another 25 basis point hike on Thursday, while the risk sensitive AUD/USD rose 0.5% to 0.6905 and USD/CNY fell 0.3% to 6.7179 after China’s industrial production unexpectedly rose 0.7% on the year in May.