The US Dollar Index (DXY) extended its advance for a third straight session, touching a fresh 13-month high of 101.60 during European trading on Wednesday, as the US Dollar (USD) strengthened against a basket of six major currencies. The move followed a Federal Reserve (Fed) decision to keep interest rates unchanged, alongside guidance that momentum for additional tightening has increased, while Chair Kevin Warsh reiterated a focus on restoring price stability. According to the CME FedWatch tool, pricing for a December rate rise has shifted sharply, with traders now assigning an 85.5% probability versus 61% ahead of last week’s FOMC meeting.
In the data, S&P Global’s Composite Purchasing Managers’ Index (PMI) rose to 52.2 in June from 51.5 in May, pointing to continued expansion. Manufacturing activity also strengthened, with the PMI at 55.7 versus 55.1 previously and above forecasts of 54.8; services registered 51.3, up from 50.7 and ahead of the 51.0 consensus. Attention now turns to the US May Personal Consumption Expenditures (PCE) report, the Fed’s preferred inflation gauge.
US Dollar Strength and Trading Opportunities
Given the US Dollar Index (DXY) is breaking to new highs, we believe the path of least resistance for the dollar is upwards in the coming weeks. We are positioning for this by looking at long DXY futures or buying call options on dollar-centric currency pairs. This view is supported by the DXY pushing past 105 in May 2024, showing that such levels are well within recent trading ranges when hawkish Fed sentiment takes hold.
The market is now pricing in an 85.5% chance of a rate hike by December, which is a significant shift. We should therefore consider strategies that benefit from rising short-term interest rates, like selling SOFR or Fed Funds futures contracts. Historically, during the 2022-2023 tightening cycle, traders who anticipated the Fed’s aggressive hikes by shorting Treasury futures saw significant gains as yields rose.
Volatility, Inflation, and Sector Divergence
With the crucial Personal Consumption Expenditures (PCE) inflation report for May pending, we anticipate a spike in volatility. We can trade this expected price swing by purchasing at-the-money straddles on major currency pairs like EUR/USD. Any significant deviation in the PCE data from the consensus forecast of a 2.7% annual rise will likely trigger a sharp move, making a volatility play attractive.
The robust PMI data, especially the jump in the manufacturing index to 55.7, indicates the US economy can absorb higher rates better than its peers. This divergence suggests we could use options to bet against sectors sensitive to high borrowing costs, such as real estate investment trusts (REITs). For example, during the last major hiking cycle, the Vanguard Real Estate ETF (VNQ) significantly underperformed the broader S&P 500.
