USD Relief Rally Seen Limited Amid Fed Credibility Concerns

The US Dollar (USD) has staged a relief rally after concerns over the Federal Reserve's (Fed) credibility eased, but analysts see limited scope for a sustained rebound. According to Brown Brothers Harriman's Elias Haddad, the USD has recovered part of its recent losses against most major currencies.

However, the recovery is expected to be shallow as the USD continues to trade in line with interest rate differentials. The Fed's credibility gap has eased, and US 5y5y inflation swaps have retraced much of their rise triggered by Fed Chair Kevin Warsh's failure to turn tough inflation rhetoric into credible policy.

The strong US labor market, wage growth consistent with the Fed's 2% inflation target, and restrictive Fed policy are all supporting the disinflation outlook. Nevertheless, there are concerns that the renewed pick-up in services price pressure suggests upside inflation risks have yet to fully recede.

US productivity growth is also a positive factor for the Fed, as it exerts a disinflationary force on the economy. The upcoming Q2 non-farm productivity report due today could help shape near-term rate expectations and influence the probability of a September rate hike, which currently stands at about 60%.