USD to avoid further decline as previous fears may soon return to market

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Since the end of March, the US dollar has been steadily declining. However, the situation may soon change. Investors may start factoring in expectations about the tightening of monetary policy, especially if the Fed reacts to signs of rising inflation in the country.

Jerome Powell and other Fed officials assure speculators that the acceleration in inflation is temporary and interest rates will remain low for a long time.

These statements abate investors' fears about inflationary risks. Besides, they are less concerned that the stock market seems overbought.

A rise in inflation is likely to become a problem for the US stock market, experts at Crescat Capital warn.

They believe that in April, the S&P 500's real yield, adjusted for inflation, fell below zero for the first time in forty years and reached the lowest levels since December 1980.

This is a consequence of the extreme overvaluation of the US stock market, experts said.

Bank of America strategists draw an analogy with 1967-1969 when the US government tried to appease various electoral groups by increasing the state budget deficit and thereby triggering a rapid increase in market rates. The Fed then took an ultra-soft approach. As a result, inflation in the country rose to multi-year highs.

The S&P 500 is up by more than 13% since the start of the year. The high indicators of the stock market can be associated with the Fed's stimulus measures and injections in the economy.

Investors are buying back the sagging stocks and other riskier assets, while simultaneously selling the safe-haven US dollar, believing that the recent surge in inflation will not lead to a tightening of the monetary policy.

"Market participants seem to share the view of Fed officials that the spike in inflation is likely to be temporary," experts at National Australia Bank said.

A temporary jump in consumer prices is unlikely to force the central bank to change its monetary policy, they added.

Recently, Jim Bullard, the president and CEO of the Federal Reserve Bank of St. Louis, said that it is too early to even start a discussion about the beginning of a reduction of the bond-buying program.

Another Fed official, Patrick Harker, said he would like to see constant improvement in the US labor market before the regulator begins the discuss the reduction of the QE program. The US economy may need to add up to 11 million jobs to mitigate the damage caused by the pandemic.

The US dollar index slid down amid such rhetoric of the regulator. On Tuesday, it broke through the lower board of its recent range, reaching its lowest levels since early January near 89.50.

USDX may aim for the lows of the current year in the area of 89.20.

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The Fed's commitment to ultra-soft monetary policy is holding back the growth of US Treasury bond yields against the background of accelerating inflation, which is weighing on the US currency.

On Monday, the 10-year Treasury bond yield sank to 1.603% from 1.629% recorded on Friday.

The US dollar may continue to drop if inflation accelerates and the Fed does not hint that it is going to adjust monetary policy.

However, the Fed is unlikely to ignore the strong macro statistics and the acceleration of inflation, which is affecting more and more segments of the economy.

In this scenario, the US currency is unlikely to experience a considerable decrease in the foreseeable future.

Moreover, the US dollar index may revise upwards if investors start to piece in more hawkish stance of the Fed.

The next few months will be very important for the market. It is not clear yet when the Fed will start talking about reducing QE. However, it depends on the results of the economic reports in this and next months. If the Fed hints at the reduction of the bond-buying program, the situation could change dramatically, strategists at Nomura believe.

On Friday, May 28, economic data on Personal Consumption Expenditures will be published. The PCE Price Index is the method preferred by the Federal Reserve to measure inflation. Undoubtedly, his report is sure to have an impact on the Fed's monetary policy.

According to forecasts, in April, the indicator grew by 3% year-on-year after rising by 1.8% a month earlier.

"The reports to be released on Friday, including data on personal consumption expenditures and inflation in the US, may trigger expectations of a more hawkish tone at the next Fed meeting on June 15-16. However, at the moment, the US dollar is under bears' control, experts at Brown Brothers Harriman said.

The US economic outlook also depends on fiscal policy, which is still uncertain.

Last Friday, Biden's administration said it had cut its infrastructure spending plan to $1.7 trillion from $2.25 trillion, cutting investment in broadband, roads and bridges, but Republicans dismissed the changes as insufficient for a deal.

In addition, according to some reports, there is growing opposition in Congress to the upcoming tax increase. Perhaps, the stimulus programs planned by the Joe Biden administration will have to be financed, as before, by issuing and increasing the national debt. This is bullish for the US currency in the medium-term.

As for the long-term outlook, analysts at Credit Agricole say that a rally in USD amid the tightening of monetary policy may run out of steam over time and the supremacy of the United States will be shaken as other countries recover from the pandemic.

The material has been provided by InstaForex Company - www.instaforex.com

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