Fed rate hike expectations cool down, US dollar falls for third consecutive day hitting lowest since May, emerging market currency index surges to all-time high

According to Zhitong Finance APP, as a series of weak U.S. economic data have completely extinguished market expectations for a Federal Reserve rate hike in September, global capital is repricing at the fastest pace in recent months. On August 17, the Bloomberg Dollar Spot Index fell for the third consecutive trading day, hitting its lowest level since May 15. Meanwhile, the MSCI Emerging Markets Currency Index rose as much as 0.2% intraday to 1906.98, reaching a record high; the Emerging Market Equities Index simultaneously climbed 0.6%, indicating a significant revival in risk appetite.

Data “Triple Whammy:” Fed September Rate Hike Probability Plummets from 75% to 30%

The dollar's persistent weakness is no coincidence. Within just two weeks, three sets of key economic data have consecutively shattered market confidence in the Fed's continuation of rate hikes.

First blow: July nonfarm payrolls unexpectedly shrink. Data released on August 7 showed U.S. nonfarm payrolls declined by 23,000 in July, against market expectations of an 80,000 increase. May and June numbers were heavily revised downward, with a combined reduction of 103,000. There are clear signs of cooling in the U.S. labor market.

Second blow: CPI and PPI cool off simultaneously. The July CPI and PPI both showed signs of weakness. The inflation data has returned to a downward trajectory, further dampening the urgency for the Fed to hike rates.

Third blow: Retail sales “disappoint” and end nine consecutive months of growth. U.S. retail sales for July, released on August 14, fell 0.6% month-on-month, far below the market's expectation of a 0.1% increase, breaking a nine-month streak of gains. The retail control group, directly related to GDP calculation, also recorded a 0.4% month-on-month decline. Consumer confidence deteriorated as living costs rose.

The combined effect of these three datasets is immediate. According to the CME FedWatch tool, the implied probability of a Fed rate hike in September has plummeted from about 75% in late July to just 30%. The U.S. swaps market is currently only fully pricing in a 25-basis-point hike by January next year, sharply contrasting with expectations just a week ago for another hike before year-end. The remaining anticipated hikes in the current tightening cycle have narrowed to about 36 basis points.

Dollar “Loses Momentum” and Emerging Markets “Celebrate”

The direct consequence of the dollar's weakness is a broad rally in emerging market assets. Wee Khoon Chong, Senior Strategist for APAC Markets at BNY Mellon, said: “Emerging market currencies are supported today, mainly driven by the weaker dollar and continued improvement in equity market risk sentiment. We are seeing a strong return of foreign capital into emerging markets, particularly in Asia.”

Carry trades are revived. As the Fed's rate hike path flattens, the relatively high interest rate advantage in emerging markets stands out again, attracting global capital in search of yield.

Geopolitical risk premium drops. Galvin Chia, Emerging Asia Strategist at Societe Generale, pointed out that the appreciation of Asian currencies results from multiple factors: “Asian currencies seem to have benefited from last week’s weak U.S. data as well as this week's initial dollar softness. The lack of new geopolitical headlines over the weekend and Brent crude prices below $90 may also be providing market support.”

The U.S. Dollar Index (DXY) has fallen to around 99.50, hovering near a two-month low. The euro against the dollar broke through the key resistance level of 1.1577 and rose above the 100-day moving average. The yen against the dollar rebounded to around 159. From a quantitative perspective, the 20-day correlation coefficient between the Citi U.S. Economic Surprise Index and the Dollar Index is as high as 0.85, making economic data surprises the core variable influencing dollar trends.

Signals from the options market are even clearer. One-month options have bet on dollar depreciation for the first time since late February, while longer-term contracts still favor the dollar.

Key Variables This Week: Can FOMC Minutes “Hawkishly Intervene”?

Whether the dollar's decline can continue will depend on two key events this week.

Wednesday (August 20): FOMC July Meeting Minutes. At the July 29 Fed meeting, rates were held steady for the fifth consecutive time in the 3.5%-3.75% range, but there were three dissenting votes—Dallas Fed President Logan, Cleveland Fed President Harker, and Minneapolis Fed President Kashkari—all advocated for a rate hike.

Chris Turner, Global Head of Markets at ING, pointed out: “If the minutes include some language suggesting that the decision to hold rates unchanged was closer than most expected, it will be difficult for the market to completely revert to a hawkish stance.”

As BNY Mellon's Chong noted, foreign capital is making a “strong rebound” into emerging markets. Societe Generale's Chia also warned that the late summer lull combined with a lack of geopolitical news may be amplifying the current volatility.

This week's FOMC minutes will be a critical litmus test for whether this trend can continue. If the minutes reveal a “reaction function” under Waller’s leadership at the Fed, it could shift market expectations for a rate hike.

Friday: PMI data. If U.S. PMI shows a widening growth advantage, it may provide some support for the dollar. Elias Haddad, Global Markets Strategist at Brown Brothers Harriman, noted, if strong U.S. economic data can cement America's growth advantage, it could boost the U.S. dollar.

The Emerging Market Currencies Index hits a record high, the dollar falls to a three-month low, and foreign capital is flowing back into Asian markets—these shifts suggest a weakening confidence in the “U.S. exceptionalism” narrative.