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US dollar index (DXY) forecast: Could higher Fed interest rates send the DXY to 121?


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In this article:
  • AUD/USD
    AUD/USD
    0.64535 USD
    -0.00737 -1.130%
  • USD/JPY
    USD/JPY
    144.649 USD
    0.556 +0.390%

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 US dollar banknote closeup. Blue tinted illustration.
"We Trust": 100 dollar bill with portrait of Benjamin Franklin in focus – Photo: Shutterstock

The September FOMC meeting delivered a new 75 basis point hike, the third consecutive of this magnitude, bringing Fed funds rates into a range of 3 to 3.25%, with Chair J Powell signaling additional hikes and a "painful" path to bring inflation back to 2%. Following the Fed's announcement, the US dollar index (DXY) climbed to its highest point since June 2002, crossing the 111-point mark, and currently settling above 113. 

In its new economic projections, the Fed lowered its previous June forecasts for economic growth in 2023, while raising estimates for both inflation and unemployment, and predicting that interest rates will reach 4.6% next year

As a direct consequence of this, the Federal Reserve will keep its monetary policy extremely tight for an extended period of time in order to accomplish its objective of achieving price stability.

This will probably continue to increase the appeal of the dollar in the forex market as interest rate differentials widen and risk aversion increases on global markets.

Speaking about the DXY forecast, is the US dollar index now on track to hit the highs of July 2001 at 121?

US dollar: greenback is King

a chart showing Price action in forex markets post FOMC meetingUS dollar performance versus major currencies – Photo: Capital.com, Source: Tradingview

On the foreign exchange market, the value of the United States dollar is currently at multi-year highs when compared to its major peers.

The following prices are for September 27, 2022:

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  • The US dollar index (DXY) traded at 113.5, the highest level since June 2002. 
  • The euro (EUR/USD) was at 0.965, its lowest level in 20 years and 15% lower year to date.
  • The British pound (GBP/USD) hovered at 1.075, at levels not seen since the all-time lows set in March 1985.
  • The Japanese yen (USD/JPY) plummeted to ¥144.3 per USD, at the lowests since September 1998. 
  • Both the New zealand dollar (NZD/USD) and the Australian dollar (AUD/USD) updated their year-to-date lows, hovering near their lowest levels since March 2020.

Federal Reserve's economic projections: More pain to come = more USD upside?

Variable2022202320242025Longer run

Change in real GDP

0.21.21.71.81.8
June projection1.71.71.9 1.8

Unemployment rate

3.84.44.44.34
June projection3.73.94.1 4

PCE inflation

5.42.82.322
June projection5.22.62.2 2

Core PCE inflation

4.53.12.32.1 
June projection4.32.72.3  

Federal funds rate

4.44.63.92.92.5

June projection

3.43.83.4 2.5

Source: Federalreserve.gov

According to the September's economic projections, the Federal Reserve expects growth to slow to 1.2% in 2023 (from 1.7% in June), the unemployment rate to rise to 4.4% (from 3.9% in June), and core PCE inflation to rise to 3.1% (from 2.7% in June).

In terms of US interest rate forecasts, the new Fed's dot-plot indicates that the median Fed funds rate will rise to 4.4% by the end of 2022 and to 4.6% in 2023. June projections for interest rates were 3.4% and 3.8%, respectively. 

Thus, interest rates in the US will continue to rise sharply and are expected to remain well above inflation projections through 2023, 2024, and 2025. This suggests the Fed will maintain its current course of extremely tight monetary policy over the next few years.

Regarding the implication for the dollar, the Federal Reserve's "Whatever it takes" strategy to reduce inflation to 2% is a clear supportive factor for the USD.

In the absence of an explicit shift in the Federal Reserve's stance, the greenback can continue to benefit from the path of rising interest rates.

AUD/USD

0.65 Price
-1.130% 1D Chg, %
Long position overnight fee -0.0011%
Short position overnight fee 0.0000%
Overnight fee time 21:00 (UTC)
Spread 0.00006

EUR/USD

0.97 Price
-0.870% 1D Chg, %
Long position overnight fee -0.0028%
Short position overnight fee 0.0008%
Overnight fee time 21:00 (UTC)
Spread 0.00006

GBP/JPY

155.95 Price
-0.640% 1D Chg, %
Long position overnight fee 0.0000%
Short position overnight fee -0.0000%
Overnight fee time 21:00 (UTC)
Spread 0.030

USD/JPY

144.65 Price
+0.390% 1D Chg, %
Long position overnight fee 0.0011%
Short position overnight fee -0.0034%
Overnight fee time 21:00 (UTC)
Spread 0.008

Additionally, the "painful path" taken by Fed Chair Jerome Powell to lower inflation to around 2% while raising unemployment and reducing growth runs the risk of increasing risk aversion on global markets and boosting demand for safe-haven assets like the dollar.

US dollar DXY index weekly chart: 121 next?

DXY weekly chart as of September 22, 2022 – Photo: Capital.com, Source: Tradingview

DXY analysis: Hard landing is needed to reach early 2000s highs

Looking at the weekly DXY chart, the next major resistance level is 121, which represents the July 2001 highs and is currently 9% above current prices. 

The DXY reached this level twice in the early 2000s, first in July 2001 and then in January 2002.

But what were the economic conditions that drove the greenback to such highs back then?

Interest rates in the US reached their peak of 6.5% in May 2000, remained unchanged until December 2000, and then started to decline rapidly, dropping to 3.5% in July 2001 and then to 1.75% in January 2002. The inflation rate peaked in July 2001 at 3.6% before dropping off quickly.

The United States' GDP growth decreased from 5.2% in June 2000 to 0.2% in December 2001. The US unemployment rate increased from 3.8% in March 2000 to 5.9% in April 2002.

In other words, it wasn't a hawkish Fed that pushed the DXY to 121 in the early 2000s, but rather a global risk-off and recession fears.

The US economy experienced a hard landing as the dot-com bubble burst and stock market indices, such as the broader S&P 500 (US 500) and the tech-heavy Nasdaq (US 100) plummeted.

DXY index; interest rates; GDP growth; unemployment rate; inflation rate; S&P 500 index: performance between 2000 and 2002 – Photo: Capital.com, Source: Tradingview

Therefore, the next leg of the greenback's appreciation over the coming months may be fueled more by recession risks and rising risk aversion in equity markets. 

It won't be a straight line ahead for the dollar. Rising unemployment, falling inflation, and slowing growth all point to a bumpy ride ahead as the market speculates on the Fed's potential dovish turn.

The more the Fed keeps monetary policy tight and real yields in the positive range while the economy is already shrinking, the more likely it is that the dollar will reach its early 2000s highs at 121.

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