Dollar index up 0.75% as markets see lower likelihood of early interest rate cuts 

On Tuesday, the dollar surged as investor expectations for a March interest rate cut from the Federal Reserve fell, while the pound and Japanese yen saw declines amid easing inflationary pressures. 

The U.S. dollar index (DXY), which measures the greenback against a basket of six major currencies, climbed by 0.76% to 103.16, reaching a one-month high. It had gained 0.2% during the subdued trading on Monday, a U.S. public holiday. 

The euro faced a 0.63% decline to $1.0884, marking its most significant one-day percentage drop in two weeks. Comments from European Central Bank (ECB) officials downplaying early rate cuts contributed to the downturn. ECB's Joachim Nagel and Robert Holzmann stressed that it was premature to discuss cuts, fostering uncertainty over the global borrowing cost outlook. 

In an overview on Tuesday, Markets.com analyst Neil Wilson said the market was likely pricing in “way too many” interest rate cuts: 
 

“Nagel said ‘It's too early to talk about cuts, inflation is too high,’ whilst Holzmann told CNBC: ‘I cannot imagine that we’ll talk about cuts yet, because we should not talk about it. Everything we have seen in recent weeks points in the opposite direction, so I may even foresee no cut at all this year.’ [emphasis my own]. I think this really goes to the point that I’ve been making for a while now – the market is pricing way too many cuts; CBs are going to look at lumpy, non-linear disinflation and not feel completely assured that they are in a position to cut. Labour market tightness provides the cover to stay higher for longer”. 

U.S. bond yields also went up on Tuesday, with the 10-year Treasury yield rising by 6 basis points to 4.011%, providing support for the dollar.  

Jane Foley, head of FX strategy at Netherlands-based Rabobank, told Reuters that a bleak outlook for Germany's economy, which shrank by 0.3% last year, was likely another factor weighing on the euro: 

"With budget cuts coming, it doesn't look good for the German economy in terms of growth for the year ahead”. 

On Tuesday, ECB data showed a notable decline in consumer inflation expectations in the euro zone three years ahead. According to a November poll, the expectations dropped from 2.5% to 2.2%. 

British pound and Japanese yen fall 

Sterling dropped by 0.71% to $1.2637 after data revealed a sharp slowdown in British wage growth for the three months through November, reinforcing expectations of substantial rate cuts by the Bank of England this year. 

The dollar strengthened by 0.58% against the Japanese yen, with the USD to JPY exchange rate reaching 146.69 yen, close to a five-week high. The yen weakened following data showing Japan's wholesale price index remained flat in December, with the rate of change decelerating for the 12th consecutive month. 

The Australian dollar, which tends to fall when investors are concerned about taking on risk in the market, declined by 0.87% to $0.6603. 

Investors awaited comments from the Fed's Christopher Waller, who’ses dovish turn in late November helped spur a year-end stock market rally. Market expectations for a 25 basis point cut in March fell slightly to 69%, compared to 77% a day earlier and 63% a week earlier, as per the CME FedWatch Tool. Traders expect cuts of roughly 160 basis points throughout the year. 

ING says Fed’s Waller may stick to disinflation message, signals resistance of 103.20 for DXY index 

Chris Turner, Head of Global Markets at the Dutch bank ING, offered a preview of Waller’s potential comments and their likely effect on the DXY index: 

“Economic data is light, but we do hear from some central bank speakers, the most important of which will be the Fed's Waller. [...] Recall that he delivered the definitive and market-moving ‘something appears to be giving’ speech in late November. Back then, it concluded that the conflict between strong US growth and disinflation appeared to be resolving in the favour of disinflation. [...] We presume today that he will stick to that same core message of successful disinflation and will not want to get involved in the fine-tuning of discussing a 2024 easing cycle, but not starting in March. We thus see event risk as a benign one – slightly negative for the dollar and positive for risk. 

DXY has clear resistance at 103.10/103.20 and the case we have outlined above suggests that these levels may well prove the top of the day's trading range. 

If we are wrong and Waller has been sent out to push back against aggressive easing expectations (market price 18 bps of a 25 bp first cut in March and 158 bp of easing this year) then DXY can break resistance and head to the 104.00/104.25 area multi-day". 

Investors were also monitoring the news concerning tensions in the Middle East and the situation in the Red Sea. An official from the Iran-aligned Houthi movement said on Monday that the group intends to expand its targets to include U.S. ships after strikes on its Yemen sites by the U.S. and British forces. 

In Iowa, Donald Trump secured a commanding win in the first 2023 presidential contest for the Republican party on Monday. Analysts suggested that this result might be marginally impacting the euro, as investors contemplate the potential implications of a more isolationist America under a Trump presidency for Europe.