Waller's dovish statement dampens rate hike expectations; US dollar falls to lowest level since May, yen surges about 2%

According to Zhitong Finance APP, the US dollar weakened significantly on Thursday, falling to its lowest level since May this year. Federal Reserve Governor Waller stated that inflation has made some progress and said the September interest rate decision will largely depend on August inflation data to be released next week, pushing the market to further reduce its bets on a Fed rate hike in September. Meanwhile, the Japanese yen appreciated sharply by about 2%, becoming the strongest performer among G10 currencies, as expectations for a Bank of Japan rate hike and speculation about potential foreign exchange intervention together increased downward pressure on the dollar.

Dollar Falls to Lowest Since May as Waller Comments Weigh on Hike Expectations

Data shows that the Bloomberg Dollar Spot Index dropped 0.6% on Thursday, recording its largest single-day decline in more than two weeks and hitting the lowest level since May.

A key catalyst for the dollar’s weakness was the shift in Fed policy expectations. On Thursday, Waller said his next interest rate decision would be “heavily influenced” by the upcoming August inflation data. His comments on progress against inflation were interpreted by the foreign exchange market as a relatively dovish policy signal.

As a result, swap contracts linked to the Fed’s September 16 interest rate decision show that the market now sees about a 50% chance of the Fed raising rates by 25 basis points. In contrast, earlier this week, markets saw roughly a 70% probability of a 25-basis-point hike in September. The rapid cooling in rate hike expectations over just a few days has weakened an important rate-supportive factor that had previously buoyed the dollar.

Bank of America FX strategist Alex Cohen said, “Waller’s remarks today sent out a dovish signal, pushing the dollar lower as the market moderately scaled back September rate hike expectations.” He further noted that if upcoming US employment or inflation data come in weak, it could put further downward pressure on the dollar.

Yen Surges About 2% as Bank of Japan Rate Hike Bets Rise

Another key reason for the dollar’s decline was the rapid strengthening of the yen. On Thursday, the yen surged about 2% against the dollar, leading the G10 currencies. Investors are further increasing their bets on a Bank of Japan rate hike, while the market remains highly alert to whether Japanese authorities might once again intervene to support the yen.

Previously, the yen had been suppressed for a long time by the US-Japan interest rate differential and Japan’s fiscal outlook. But recently, hawkish policy signals from Bank of Japan officials have led the market to reassess Japan’s rate path. At the same time, the yen’s recent volatility has kept FX traders highly vigilant, closely watching whether the Japanese government and central bank might take action to stabilize the exchange rate.

Fed September Rate Hike Bets Fall from Around 70% to Even Odds

The market’s expectations for the Fed’s September policy path have changed noticeably recently. Previously, continued inflation pressures in the US and hawkish signals from Fed Chair Walsh at the Jackson Hole central bank symposium caused investors to significantly ramp up bets on a September rate hike.

But the latest economic data and Fed officials’ comments are changing those expectations. Waller stated that the August inflation data would have a major influence on his policy decision, signaling that if inflation continues to cool, he may lean toward holding rates steady in September.

Currently, odds for a 25 basis-point hike in September have dropped from roughly 70% earlier this week to about 50%, indicating that investors are now divided on whether the Fed will further tighten policy. This makes the upcoming August inflation data a key catalyst for the dollar’s next move.

Market Turns to Friday Non-Farm Payrolls as Jobs Data to Decide Dollar’s Near-Term Path

Before the inflation data is released, investors will first get the US monthly jobs report on Friday. The importance of the employment data lies in the fact that if there are further signs of cooling in the US labor market, the necessity for further Fed rate hikes may decrease. Recently released initial jobless claims data have already signaled some softness, prompting the market to trim September rate hike bets.

If the Friday jobs report is again weaker than expected, the market could further lower its expectations for a September rate hike, continuing to depress US Treasury yields and the dollar. Conversely, if the labor market remains strong and the subsequent August inflation data is higher than expected, rate hike expectations could pick back up.

Diverging US-Japan Policy Bets Put Dollar to the Test Ahead of Key Data

Overall, Thursday’s sharp drop in the dollar was not due to a single factor, but rather the simultaneous cooling of Fed rate hike expectations and rising Bank of Japan rate hike bets.

Waller’s comments on inflation progress weakened market confidence in further Fed tightening in September, dropping the probability of a 25-basis-point hike from about 70% earlier this week to even odds; meanwhile, increased bets on a Bank of Japan rate hike and vigilance over possible FX intervention spurred a roughly 2% surge in the yen against the dollar.

Under this dual pressure, the Bloomberg Dollar Spot Index fell 0.6%, reaching its lowest level since May.

Looking ahead, the dollar will face two key US economic data tests in succession. First comes Friday’s jobs report, followed by next week’s August inflation data. If both the employment and inflation numbers show further cooling, markets may keep paring back September Fed hike bets, piling more pressure on the dollar. Conversely, any much stronger than expected data could swiftly change current rate expectations.