Inflation and the Fed Will Test Dollar Strength

The U.S. Dollar Index (DXY) has risen by 0.3% to 105.20 points this week, while the EURUSD has slipped by 0.4% to 1.07590, although it was lower at 1.07330 on Monday. The Greenback's strength has been evident since last Friday following a mixed U.S. labor market report for May. Nonfarm Payrolls increased to 272,000, surpassing the expected 182,000, while the unemployment rate edged up to 4.0% from the expected 3.9%. Additionally, hourly earnings accelerated to 0.4% MoM, above the expected 0.3%.

These developments led to an immediate 0.8% strengthening of the Dollar. Previously, investors had high expectations of Federal Reserve (Fed) interest rate cuts in September, with bets on rate cuts over 60% last Wednesday and Thursday. However, after the labor market report, these bets dropped below 50.0%. Consequently, U.S. 10-year debt yields jumped to 4.43% from 4.29%, which is favorable for the Dollar.

Despite this, large investors are cautious about buying the Greenback. The WisdomTree Bloomberg US Dollar Bullish Fund (USDU) reported net fund outflows of $38.6 million after nine weeks of net inflows, marking the largest outflow since December 2023.

The U.S. Dollar may continue to strengthen due to disappointing parliamentary elections in the European Union, where far-right parties increased their representation in the EU Parliament, potentially undermining European unity. The EURUSD opened the week 0.6% lower, creating a price gap on Monday. The upper margin of this gap is at 1.08000. For the Dollar to continue strengthening, the EURUSD needs to retest this level and close the gap, possibly this week, likely on Wednesday, when U.S. inflation data for May is released.

Wall Street expects a slight slowdown in inflation, which might close the gap. The Fed will announce its meeting results a few hours after the inflation data release, and policymakers will provide a dot plot interest rate forecast, offering guidelines for the timing of interest rate cuts. A hawkish Fed could push the EURUSD further down to 1.05000, while dovish tones might lead to a rise to 1.08000, introducing more uncertainty into the market.