Fed Rate Cut Hopes Evaporate as Dollar Index Hits Monthly Peak

Market Sentiment Shifts on Mixed Economic Signals

The US dollar has surged to its highest point in four weeks, with the currency index climbing 0.20% on Friday as market participants reassess their expectations for Federal Reserve policy. The driver? A puzzling employment report that simultaneously disappointed and impressed: payroll growth came in below targets while unemployment ticked lower and wage increases exceeded forecasts. This contradictory narrative has sparked a dramatic fade in speculation about near-term interest rate cuts.

The probability of a 25 basis point reduction at the January 27-28 FOMC meeting has essentially collapsed to just 5%, a stark reminder that the Fed remains focused on fighting persistent inflation rather than accommodating growth concerns.

The Jobs Report That Changed Everything

Dig into the employment data and you’ll find reason for caution on both sides of the economic debate:

Where Growth is Failing: December nonfarm payrolls rose just 50,000—a dramatic miss against the 70,000 forecast. November’s number was also revised downward to 56,000 from 64,000, suggesting the labor market cooling is more pronounced than initially thought. Meanwhile, October housing starts experienced a sharp drop of 4.6% month-over-month, falling to 1.246 million—the lowest reading in five and a half years and well below the anticipated 1.33 million.

Where Strength Persists: The unemployment rate fell 0.1 percentage points to 4.4%, beating the 4.5% expectation. Perhaps more notably, average hourly earnings accelerated to 3.8% year-over-year growth, outpacing the 3.6% prediction. This wage pressure remains a key concern for policymakers fighting to bring inflation down.

On the consumer front, January sentiment rose more than expected, with the University of Michigan index climbing 1.1 points to 54.0 versus the forecasted 53.5. However, inflation expectations showed stubbornness, with one-year forecasts holding steady at 4.2% and longer-term expectations rising to 3.4%.

The Rate Cut Narrative in Steep Decline

What does it all mean for 2026? Markets are now pricing in roughly 50 basis points of Fed easing this year—a sharp drop from earlier assumptions. Yet this narrative faces significant headwinds. Atlanta Fed President Raphael Bostic reinforced hawkish messaging Friday, emphasizing that inflation concerns remain despite labor market moderation.

The outlook grows more complicated when considering global monetary policy divergence. While the Fed is expected to cut rates, the Bank of Japan looks poised to tighten by 25 basis points, and the European Central Bank is likely to hold steady. Currency traders are already factoring in these divergent paths.

Adding to dollar support, the Fed continues injecting liquidity through Treasury purchases ($40 billion initiated in mid-December), while speculation swirls around President Trump’s forthcoming Fed Chair selection—potentially a more dovish candidate like Kevin Hassett, according to Bloomberg reporting.

The Supreme Court Tariff Ruling: A Wild Card

One more factor buoying the greenback Friday: the Supreme Court’s decision to postpone its ruling on Trump’s tariff legality until Wednesday. Should the tariffs ultimately face legal challenges or reversal, the dollar could face pressure as reduced tariff revenue might widen the already-concerning US budget deficit.

Euro Slips as Dollar Strength Fades Old Expectations

The EUR/USD pair fell 0.21% to a one-month low, though the decline proved modest thanks to better-than-expected economic data. Eurozone retail sales rose 0.2% month-over-month in November (versus 0.1% forecast), while German industrial production unexpectedly jumped 0.8% after forecasters predicted a 0.7% decline.

ECB Governing Council member Dimitar Radev signaled satisfaction with current rates given present conditions, and swap markets assign barely 1% probability to a rate hike at February’s policy meeting.

Yen Drops to One-Year Low as USD/JPY Rallies

The dollar’s strength was nowhere more evident than against the yen, with USD/JPY climbing 0.66% Friday. The yen has fallen to its weakest level in a year as the Bank of Japan stays accommodative—markets see zero chance of a rate hike at January’s meeting despite the BOJ raising its growth forecast.

Japan’s labor market and leading indicators remain resilient: November household spending surged 2.9% year-over-year (well above the 1% decline expected), and the leading index hit a 1.5-year high at 110.5. Yet the yen faced multiple headwinds including geopolitical tensions with China, political uncertainty around potential parliamentary dissolution, and the government’s plan to boost defense spending to a record 122.3 trillion yen ($780 billion) in the next fiscal year.

Precious Metals Soar Despite Dollar Rally

Gold and silver staged impressive rallies Friday despite the dollar’s strength, suggesting other factors are driving safe-haven demand. February COMEX gold settled up $40.20 (+0.90%), while March COMEX silver exploded higher by $4.197 (+5.59%).

The catalyst: President Trump’s directive for Fannie Mae and Freddie Mac to purchase $200 billion in mortgage bonds—a quantitative easing-style stimulus aimed at housing support. Combined with geopolitical uncertainties spanning US trade policy, Ukraine, Middle East tensions, and Venezuelan instability, investors turned to precious metals for protection.

Central bank accumulation provides additional support. China’s central bank added 30,000 ounces of gold reserves in December alone, marking fourteen straight monthly increases. Globally, central banks purchased 220 metric tons during the third quarter—a 28% jump from the prior quarter. Gold ETF holdings reached a 3.25-year peak and silver ETF holdings hit a 3.5-year high, underscoring sustained investor interest.

That said, headwinds emerged from a record S&P 500 close and potential commodity index rebalancing. Citigroup warns that up to $6.8 billion could exit gold futures with similar outflows from silver due to index reweighting—a risk that could trigger a sharp price decline.