Fed's Rate-Cut Outlook Dims as Dollar Strengthens on Mixed Economic Signals

Central Bank Policy Divergence Reshapes Currency Markets

With the FOMC meeting schedule set for January 27-28, market expectations for interest rate reductions have shifted dramatically. The Federal Reserve’s stance has become increasingly cautious, with traders currently pricing in only a 5% probability of a 25 basis point cut at the upcoming FOMC meeting. This contrasts sharply with earlier expectations, as hawkish economic data has prompted reconsideration of rate-cut timelines throughout 2026.

The policy divergence between major central banks is becoming more pronounced. While the Fed appears reluctant to cut rates, the Bank of Japan is expected to raise by 25 basis points, and the European Central Bank is projected to maintain its current stance. This disparity in policy direction provides structural support to the US dollar, which reached a one-month high on Friday with a 0.20% gain in the dollar index.

Atlanta Fed President Raphael Bostic reinforced this cautious tone on Friday with comments emphasizing lingering inflation concerns despite some softening in labor market conditions. Additionally, speculation surrounding President Trump’s potential Federal Reserve Chair appointment—possibly dovish candidate Kevin Hassett according to Bloomberg reporting—has created near-term volatility, though no official announcement is expected until early 2026.

Employment and Inflation Data Complicate Rate-Cut Narrative

Recent US economic data presents a mixed picture that challenges straightforward rate-cut expectations. December nonfarm payrolls increased by only 50,000, falling short of the 70,000 forecast, while November’s figure was revised downward to 56,000 from 64,000. This suggests labor market momentum may be cooling more than initially believed.

However, other employment metrics remained resilient. The December unemployment rate dropped 0.1 percentage points to 4.4%, outperforming the anticipated 4.5% reading. Average hourly earnings climbed 3.8% year-over-year, exceeding the 3.6% forecast and signaling continued wage pressure that complicates inflation concerns.

Inflation expectations remain sticky despite Fed officials’ hopes for further cooling. One-year inflation expectations held at 4.2% in January, above the anticipated 4.1% decline. More concerning for policymakers, five-to-ten-year inflation expectations rose to 3.4% from December’s 3.2%, overshooting the 3.3% forecast. This longer-term inflation perception may influence the Fed’s willingness to move forward aggressively with rate reductions.

Housing Market Weakness and Consumer Resilience

The housing sector continues to show vulnerability. October housing starts fell 4.6% month-over-month to 1.246 million, marking the lowest level in five and a half years and missing the 1.33 million forecast. Building permits for October edged down 0.2% to 1.412 million, though this figure still beat the 1.35 million expectation.

Consumer sentiment, by contrast, demonstrated surprising strength. The University of Michigan’s consumer sentiment index for January rose 1.1 points to 54.0, surpassing the expected 53.5. This resilience suggests households remain relatively optimistic despite economic crosscurrents, potentially supporting consumer spending in coming months.

Euro Faces Headwinds Despite Data Stability

The euro slipped to a one-month low on Friday, declining 0.21% as the dollar strengthened. EUR/USD weakness reflects the broader dollar strength narrative, though eurozone fundamentals provided some support. November retail sales increased 0.2% month-over-month, beating the 0.1% estimate, with October’s figure revised up to 0.3% from flat. German industrial production rose 0.8% month-over-month in November, defying expectations for a 0.7% decline.

ECB Governing Council member Dimitar Radev stated that current interest rates remain appropriate given available data and inflation dynamics. Market pricing shows only a 1% probability of a 25 basis point rate hike at the February 5 ECB policy meeting, suggesting the central bank will maintain its cautious approach.

Japanese Yen Pressured by Policy Divergence and Geopolitical Tensions

The dollar/yen pair strengthened 0.66% on Friday, pushing the yen to a one-year low against the greenback. The Bank of Japan is likely to maintain unchanged rates at its upcoming January 23 meeting, even as it raises its economic growth forecast. This accommodative stance, combined with higher US Treasury yields, pressures the yen’s relative attractiveness.

Japan’s November economic data showed surprising strength. The leading economic index reached a 1.5-year high at 110.5, matching expectations, while household spending jumped 2.9% year-over-year—the largest increase in six months and well above the anticipated 1% decline. Despite this data strength, the yen faces structural headwinds from political uncertainty following reports that Prime Minister Takaichi may dissolve the lower house.

Escalating geopolitical risks further weigh on the yen. Rising tensions between China and Japan, including new Chinese export controls on items with potential military applications, add uncertainty. Japan’s government plans to increase defense spending to a record 122.3 trillion yen ($780 billion) in the next fiscal year, elevating fiscal concerns and pressuring the currency.

Precious Metals Catch Bid on Easing Expectations and Safe-Haven Demand

February COMEX gold settled up $40.20 (+0.90%) on Friday, while March COMEX silver ended up $4.197 (+5.59%). This rally was triggered by President Trump’s directive for Fannie Mae and Freddie Mac to purchase $200 billion in mortgage bonds—effectively a form of quantitative easing aimed at lowering borrowing costs and stimulating housing demand.

This policy move increased safe-haven demand for precious metals amid persistent global uncertainties. Ongoing geopolitical tensions spanning US tariff policies, Ukraine conflicts, Middle East instability, and Venezuelan developments continue supporting gold and silver demand. Expectations of a more accommodative Federal Reserve throughout 2026, coupled with increased system liquidity from Fed Treasury bill purchases ($40 billion initiated in mid-December), further bolster precious metals appeal.

However, headwinds emerged from the dollar’s four-week peak on Friday and potential commodity index rebalancing. Citigroup estimates suggest up to $6.8 billion could exit gold futures, with similar outflows from silver, due to major commodity index reweighting. Additionally, the S&P 500’s record close on Friday reduced safe-haven demand for metals.

Central bank accumulation remains a crucial support mechanism. China’s central bank increased gold reserves by 30,000 ounces in December, marking the fourteenth consecutive monthly increase. The World Gold Council reported global central banks purchased 220 metric tons of gold in the third quarter, representing a 28% increase from the prior quarter. Investor enthusiasm 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, suggesting institutional conviction in precious metals’ longer-term value proposition.