MUFG: USD Strengthens

The US dollar is on track to strengthen for the second consecutive week although it has lost some upward momentum heading into next week.

The US dollar’s upward momentum was dampened yesterday by latest US economic data releases and comments from New York Fed President Williams that have triggered a reversal of the recent hawkish repricing of Fed rate hike expectations.

The 2-year US Treasury yield has dropped around 7bps from yesterday high and moved back closer to where it was trading prior to last week's FOMC meeting.

US yields and US dollar fell after the release of the latest US GDP data for Q1 which revealed that consumer spending slowed more than previously reported by only 0.5% down from 1.4%.

The downward revision (-1.3ppts) was mainly driven by services consumption.

It was the slowest quarter of personal consumption growth since Q1 2022.

It has cast some doubt on the resilience of the US economy with fiscal support from President Trump's tax cuts set to fade during the second half of the year.

Import growth was also revised down alongside personal consumption which more than offset the hit to GDP growth in Q1.

The breakdown of growth in Q1 reveals that the economy was driven by a pick-up in capital expenditure which increased sharply by 15.8% reflecting the ongoing AI roll out, and government spending which increased strongly by 4.4%.

In contrast, the latest US PCE deflator report contained few surprises which in the current circumstances of upside inflation risks provided some temporary relief for financial markets and the Fed.

The report revealed that the core PCE deflator increased for the second consecutive month by 0.3%M/M in May lifting the annual rate up to 3.4%.

The core PCE deflator was driven by services inflation with portfolio management fees increasing by 4.9%, air transportation by 3.1% and healthcare by 0.4%.

In contrast, the core goods deflator fell by -0.1%M/M.

Evidence of slowing inflation in the coming months will be required to prevent the Fed from backing up tough talk with rate hikes.

The correction lower for US yields and the US dollar yesterday was also encouraged by comments from New York Fed President Williams.

He stated that “the current stance of monetary policy is well positioned to do that' when referring to resorting inflation to our 2% longer-run goal on a sustained basis.

However, he did acknowledge that inflation is "unquestionably elevated' driven by tariffs, an energy shock from the Iran war and an investment boom in AI.

He is wary that the investment boom in AI may push up prices more than expected, and global supply disruptions stemming from the conflict in the Middle East remain a source of risk to both growth and inflation outlooks.

He expects inflation to ease back to 3.5% by year-end and then continue to slow on a glide path toward 2.0% reaching the target in 2028.

He noted that the fade effects of trade tariffs and slowing shelter costs should help to ease inflation in the coming quarters.

Energy and goods prices should also stabilize if the conflict is resolved relatively soon.

Overall, the comments are supportive of our view that the Fed will look through the energy price shock by leaving rates on hold this year, although he has consistently been at the more dovish end of the spectrum.

If the Fed does not follow through with rate hikes, we expect the US dollar to re-weaken later this year.