Fed's Hawkish Signals Drive Dollar to Monthly Highs as Rate Cut Bets Evaporate

Shifting Market Expectations on Monetary Policy

The US dollar experienced a significant rally on Friday, with the Dollar Index climbing 0.20% to reach its strongest level in one month. This surge reflects shifting market sentiment regarding the Federal Reserve’s interest rate trajectory. Rather than anticipating rate cuts, traders are now pricing in a prolonged holding pattern, with only a 5% probability assigned to a 25 basis point reduction at the January 27-28 FOMC meeting.

The catalyst for this shift came from a complex employment picture that ultimately favored the hawkish narrative. December nonfarm payrolls increased by 50,000—notably below the 70,000 consensus—while November’s reading was revised downward to 56,000. Simultaneously, the unemployment rate unexpectedly tightened, dropping 0.1 percentage points to 4.4% versus the expected 4.5%. More significantly, average hourly earnings surged to 3.8% year-over-year, beating the 3.6% forecast and reigniting inflation concerns among rate-setters.

Additional strength emerged from University of Michigan consumer sentiment data, which jumped 1.1 points to 54.0 in January, exceeding expectations of 53.5. Atlanta Fed President Raphael Bostic reinforced the hawkish tone on Friday, emphasizing that inflationary pressures persist despite some labor market softening.

However, long-term inflation expectations painted a murkier picture. January one-year expectations held at 4.2%—above the anticipated 4.1%—while the five-to-ten-year gauge climbed to 3.4% from December’s 3.2%, surpassing the 3.3% forecast.

Housing Data Signals Growing Structural Headwinds

The construction sector provided an additional headwind to growth assumptions. October housing starts collapsed 4.6% month-over-month to 1.246 million units, marking the lowest level in five-and-a-half years and falling well short of the 1.33 million estimate. Building permits, a forward-looking indicator, slipped 0.2% to 1.412 million, though this modest decline still exceeded the 1.35 million consensus.

Dollar’s Rally Faces Headwinds from Trump’s Tariff Uncertainty

Despite the greenback’s strength, significant uncertainty hangs over its medium-term direction. The Supreme Court’s decision to delay a ruling on the constitutionality of President Trump’s tariffs until next Wednesday introduces a major risk factor. Should tariffs face legal invalidation, the dollar could reverse course, as the loss of tariff-derived revenue would likely expand the already-substantial US fiscal deficit.

Adding to this uncertainty, speculation has mounted that President Trump may appoint a dovish Federal Reserve Chair—potentially Kevin Hassett, according to Bloomberg reporting—with the announcement expected in early 2026.

The Fed’s QE-Lite Strategy Complicates the Picture

Underlying dollar weakness persists from the Federal Reserve’s liquidity management operations. The central bank initiated $40 billion in Treasury bill purchases in mid-December, effectively injecting liquidity into the financial system. Combined with market expectations for approximately 50 basis points of rate cuts in 2026, this dovish backdrop creates a structural headwind for the currency.

Euro Struggles Despite Eurozone Resilience

The euro retreated to one-month lows on Friday, sliding 0.21% against the strengthening dollar. However, losses remained contained as Eurozone economic data offered modest support. November retail sales expanded 0.2% month-over-month, beating the 0.1% expectation, with October revised upward to 0.3% from flat. German industrial production surprised to the upside, rising 0.8% in November versus forecasts for a 0.7% decline.

ECB Governing Council member Dimitar Radev signaled satisfaction with the current policy stance, commenting that existing rates remain appropriate given the data backdrop. Swaps pricing reflects only a 1% probability of a 25 basis point rate hike at the February 5 policy decision.

Yen Hits Year-Low as BOJ Stays on Hold

The yen deteriorated further, with USD/JPY climbing 0.66% on Friday to levels not seen in a year. The Bank of Japan is widely expected to maintain rates at its upcoming January 23 meeting, despite raising its growth forecast. Political instability in Japan—including speculation that Prime Minister Takaichi may dissolve the lower house of parliament—has compounded pressure on the yen.

Japanese economic data showed surprising strength, with November’s leading economic index reaching a 1.5-year high at 110.5, matching expectations. Household spending jumped 2.9% year-over-year, the largest six-month increase and well above the expected 1% contraction. Nevertheless, these gains could not offset currency headwinds stemming from higher US Treasury yields and geopolitical tensions. Rising US-China trade friction, including new Beijing export controls on military-applicable technology, has weighed on regional sentiment.

Japan’s government plans to boost defense spending to a record 122.3 trillion yen—approximately equivalent to 70000 yen to euro conversion at current rates—generating fiscal sustainability questions that further pressure the currency.

Precious Metals Rally on Monetary Accommodation and Geopolitical Risk

Gold and silver prices surged following President Trump’s directive for Fannie Mae and Freddie Mac to purchase $200 billion in mortgage bonds—a quantitative easing–adjacent measure aimed at stimulating the housing sector. February COMEX gold settled up $40.20 (+0.90%), while March silver ended 5.59% higher at $4.197 per ounce above the prior close.

Geopolitical uncertainties spanning US tariff policy, Ukraine tensions, Middle East volatility, and Venezuelan instability continue underpinning safe-haven demand. Expectations of Fed accommodation in 2026 and increased system liquidity further boost precious metals appeal.

Nevertheless, headwinds emerged from two quarters. The dollar’s monthly high pressured commodity valuations, while Citigroup analysis projects that commodity index rebalancing could trigger significant outflows. The research firm estimates up to $6.8 billion may exit gold futures, with comparable amounts leaving silver, as major indexes reweight holdings. Additionally, the S&P 500’s record close on Friday reduced immediate safe-haven demand.

Central bank accumulation remains a critical price floor. China’s People’s Bank increased gold reserves by 30,000 ounces in December, marking the fourteenth consecutive monthly gain. Globally, central banks purchased 220 metric tons in the third quarter, representing a 28% increase from the prior quarter, according to the World Gold Council.

Retail investor participation 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, signaling sustained conviction among market participants.