Dollar Rises as Hopes for Fed Rate Reduction Fade

Dollar Index Surges to One-Month Peak

The US dollar index reached its highest level in a month on Friday, closing with a gain of 0.20%. The greenback was buoyed by a mixed US employment report: while job growth lagged expectations, the unemployment rate edged lower and average hourly earnings surpassed forecasts. These developments, seen as hawkish, may prompt the Federal Reserve to hold off on cutting interest rates. Further support for the dollar came after the University of Michigan reported a stronger-than-anticipated rise in January consumer sentiment.

Additional upward momentum for the dollar followed the Supreme Court’s decision to postpone a ruling on the legality of President Trump’s tariffs until next Wednesday. Should the tariffs be overturned, the dollar could face headwinds, as the loss of tariff revenue might exacerbate the US budget deficit.

Key US Economic Indicators

• December nonfarm payrolls increased by 50,000, below the expected 70,000. November’s figure was revised down to 56,000 from 64,000.
• The unemployment rate for December dropped by 0.1 percentage points to 4.4%, beating the anticipated 4.5%.
• Average hourly earnings in December climbed 3.8% year-over-year, outpacing the 3.6% forecast.
• October housing starts fell 4.6% month-over-month to 1.246 million, the lowest in five and a half years and below the expected 1.33 million. Building permits for October, a leading indicator for future construction, slipped 0.2% to 1.412 million, but still exceeded the forecast of 1.35 million.
• The University of Michigan’s consumer sentiment index for January rose by 1.1 points to 54.0, surpassing the expected 53.5.
• One-year inflation expectations for January held steady at 4.2%, higher than the anticipated drop to 4.1%. Five-to-ten-year inflation expectations increased to 3.4% from December’s 3.2%, above the 3.3% forecast.

Atlanta Fed President Raphael Bostic made comments on Friday that were interpreted as slightly hawkish, emphasizing persistent inflation concerns despite some cooling in the labor market.

Market participants currently assign a 5% probability to a 25 basis point rate cut at the upcoming FOMC meeting scheduled for January 27-28.

Outlook for the Dollar and Central Bank Policy

The dollar remains under pressure as markets anticipate the Federal Reserve will reduce interest rates by approximately 50 basis points in 2026. In contrast, the Bank of Japan is expected to raise rates by 25 basis points, while the European Central Bank is projected to keep rates steady that year.

Additional downward pressure on the dollar stems from the Fed’s ongoing liquidity injections, with $40 billion in Treasury bill purchases initiated in mid-December. Speculation that President Trump may appoint a dovish Fed Chair—potentially Kevin Hassett, according to Bloomberg—has also weighed on the currency. Trump has indicated he will announce his choice for Fed Chair in early 2026.

Euro and Yen Performance

The euro (EUR/USD) slipped to a one-month low on Friday, declining 0.21% as the dollar strengthened. However, the euro’s losses were limited by better-than-expected Eurozone retail sales for November and an unexpected rise in German industrial production.

• Eurozone November retail sales increased by 0.2% month-over-month, surpassing the 0.1% estimate. October’s figure was revised up to 0.3% from flat.
• German industrial output for November rose 0.8% month-over-month, defying expectations for a 0.7% decline.

ECB Governing Council member Dimitar Radev commented that current interest rates are appropriate given the available data and inflation outlook. Swaps indicate only a 1% chance of a 25 basis point ECB rate hike at the next policy meeting on February 5.

The dollar/yen pair (USD/JPY) climbed 0.66% on Friday, with the yen dropping to a one-year low against the dollar. Bloomberg reported that the Bank of Japan is likely to keep rates unchanged at its upcoming meeting, even as it raises its economic growth forecast. The yen also faced pressure from higher US Treasury yields and political uncertainty in Japan, following reports that Prime Minister Takaichi may dissolve the lower house of parliament.

• Japan’s November leading index (CI) reached a 1.5-year high at 110.5, matching expectations.
• Household spending in Japan for November jumped 2.9% year-over-year, the largest increase in six months and well above the expected 1% decline.

Rising tensions between China and Japan, including new Chinese export controls on items with potential military applications, have also weighed on the yen. Additionally, Japan’s government plans to increase defense spending to a record 122.3 trillion yen ($780 billion) in the next fiscal year, further fueling fiscal concerns. Markets currently see no chance of a Bank of Japan rate hike at the January 23 meeting.

Precious Metals Rally Amid Policy Moves and Global Risks

• February COMEX gold settled up $40.20 (+0.90%) on Friday.
• March COMEX silver ended the day up $4.197 (+5.59%).

Gold and silver prices surged after President Trump instructed Fannie Mae and Freddie Mac to purchase $200 billion in mortgage bonds, a move aimed at lowering borrowing costs and stimulating the housing market. This action, viewed as a form of quantitative easing, has increased demand for precious metals as a safe haven.

Ongoing geopolitical uncertainties—including US tariff policies and tensions in Ukraine, the Middle East, and Venezuela—continue to support precious metals. Expectations of a more accommodative Fed in 2026, along with increased liquidity in the financial system, are also boosting demand for gold and silver.

However, the dollar’s rally to a four-week high on Friday weighed on metals, and concerns about commodity index rebalancing may lead to significant outflows from gold and silver futures. Citigroup estimates suggest up to $6.8 billion could exit gold futures, with a similar amount leaving silver, due to the reweighting of major commodity indexes. Additionally, the S&P 500’s record high on Friday reduced safe-haven demand for precious metals.

Central bank demand remains a key support for gold prices. China’s central bank increased its gold reserves by 30,000 ounces in December, marking the fourteenth consecutive monthly rise. The World Gold Council also reported that global central banks bought 220 metric tons of gold in the third quarter, a 28% increase from the previous quarter.

Investor interest in precious metals remains robust, with gold ETF holdings reaching a 3.25-year high and silver ETF holdings hitting a 3.5-year peak in late December.