US Dollar strengthens as Fed rate hike fears grow

• US dollar remains strong despite weakening consumer sentiment: The University of Michigan Consumer Sentiment Index fell to 46.3 in October, signaling growing financial pressure on American households and concerns about future consumer spending.
• Rising inflation expectations fuel speculation about further Fed rate hikes: US consumers expect inflation to reach 4.7% over the next 12 months, while markets price in an approximately 71% probability of another Federal Reserve interest rate hike in December.
• High Treasury yields and geopolitical risks support the USD outlook: EURUSD remains near 1.1190, supported by expectations of restrictive monetary policy and safe-haven demand, although weakening consumption could limit further dollar gains.

The US dollar remains strong despite the latest macroeconomic data pointing to deteriorating financial conditions among American households. Rising inflation expectations, elevated Treasury yields, and concerns about further interest rate hikes by the Federal Reserve continue to support the US currency. Investors are increasingly focused on the risk of persistently high inflation, which could force the Fed to tighten monetary policy further, even as consumer spending weakens and economic growth slows.

US consumer sentiment falls to historically low levels

The latest data from the University of Michigan indicate a significant deterioration in US consumer sentiment in early October. The preliminary consumer sentiment index fell to 46.3 points, reaching its lowest level since May and coming in below economists' expectations of 47.6 points. Particularly concerning was the assessment of current economic conditions, with the corresponding index dropping from 50.9 to a record low of 44.7 points. Meanwhile, the consumer expectations index rose from 46.3 to 47.3 points, marking its first increase since July.

The deterioration in sentiment is primarily driven by rising living costs, high fuel prices, expensive borrowing, and signs of weakening labor market conditions. Lower-income households are experiencing the greatest pressure, as spending on essential goods and services accounts for a substantial share of their budgets. Additionally, consumers' assessment of durable goods buying conditions fell to an all-time low, reflecting their declining purchasing power.

Despite weak sentiment, US consumer spending remains relatively strong, supported by the labor market and previous increases in financial asset prices. However, growing evidence suggests that consumption could slow in the coming months. Only 31% of respondents say they intend to maintain their current spending levels over the next year, while more than half plan to cut back on purchases, including spending on cars, restaurants, and vacations.

Rising inflation expectations increase pressure on the Fed

From a foreign exchange market perspective, the renewed increase in inflation expectations is particularly significant. American consumers expect prices to rise by 4.7% over the next 12 months, compared with 4.6% in September. Over the longer-term horizon of five to ten years, expected average annual inflation stands at 3.5%, remaining well above the Federal Reserve's 2% inflation target.

Persistent price pressures are putting the Fed in an increasingly difficult position. On the one hand, deteriorating consumer sentiment and signs of a slowdown in the labor market argue for caution when considering further interest rate increases. On the other hand, elevated inflation expectations could make it more difficult to bring inflation back to target, limiting the central bank's room to ease monetary policy.

For the US dollar, this creates a potentially favorable environment. If the Fed is forced to maintain restrictive financial conditions for longer than previously anticipated, US assets could remain attractive to international investors. At the same time, the growing risk of a combination of weak economic growth and persistent inflation is increasing uncertainty about the future health of the US economy.

Markets increasingly price in further interest rate hikes

One of the most important factors supporting the dollar is the shift in expectations regarding the Federal Reserve's future policy decisions. Following September's 25-basis-point interest rate hike, investors are increasingly pricing in the possibility of further monetary tightening before the end of 2026.

According to CME FedWatch data, the probability of another interest rate hike at the Fed's October meeting stood at approximately 19%. This indicates that keeping interest rates unchanged remains the dominant scenario. Expectations for December, however, paint a markedly different picture, with markets assigning an approximately 71% probability to an interest rate increase.

These expectations suggest that investors increasingly view a potential pause in October as temporary rather than as the definitive end of the monetary tightening cycle. Further support for this scenario comes from the minutes of the Fed's September meeting, which indicate that most central bank officials acknowledge the possibility that additional interest rate increases may be necessary before the end of the year.

The shift in monetary policy expectations has a direct impact on the foreign exchange market. The prospect of higher interest rates tends to push US Treasury yields higher, increasing the attractiveness of dollar-denominated assets. At the same time, it limits the potential for dollar depreciation, particularly against currencies issued by countries whose central banks may pursue less restrictive monetary policies.

Dollar benefits from high treasury yields and geopolitical uncertainty

Additional support for the USD comes from heightened geopolitical tensions in the Middle East. The conflict and associated disruptions to energy markets are contributing to rising commodity prices, increasing the risk of persistently elevated inflation. At the same time, geopolitical uncertainty periodically boosts demand for the US dollar, which remains one of the world's most important reserve currencies.

As a result, the US currency is receiving support from two directions. On the one hand, investors expect interest rates to remain elevated. On the other, they are seeking liquid assets amid heightened market uncertainty. The combination of these factors could limit the extent of dollar corrections, even in response to weaker economic data.

Weakening consumer spending could threaten further USD gains

Despite a monetary policy environment that remains favorable for the dollar, there is a growing risk that deteriorating financial conditions among American households will begin to weigh on economic growth prospects. Consumer spending remains the primary engine of the US economy, meaning that a significant slowdown could change expectations regarding future Fed decisions.

A particularly important question will be whether consumers' stated intentions to reduce spending are reflected in retail sales and personal consumption data. So far, weak consumer sentiment has not translated into an equally sharp decline in actual spending. However, persistently high living and borrowing costs could gradually undermine household resilience.

For the foreign exchange market, the key issue will be the relationship between the pace of the economic slowdown and the persistence of inflation. If price pressures remain elevated, the Fed may continue pursuing restrictive monetary policy despite weaker economic activity data, which should support the dollar. However, if labor market conditions deteriorate and consumer spending weakens more sharply than expected, investors may begin scaling back their bets on further interest rate hikes.

US Dollar outlook: Will the USD continue to strengthen?

In the short term, the macroeconomic environment continues to favor a relatively strong US dollar. Rising inflation expectations, elevated Treasury yields, and the market-implied probability of a December interest rate hike all point to sustained demand for the US currency. Geopolitical uncertainty provides an additional source of support for the USD by increasing investor interest in safer and more liquid assets.

At the same time, the scope for further dollar appreciation will depend on upcoming macroeconomic releases. Particular attention will be paid to CPI and PCE inflation figures, labor market conditions, and consumer spending data. These indicators will help determine whether the US economy can sustain growth despite high borrowing costs and deteriorating household sentiment.

Over the coming weeks, the balance of factors remains in favor of the dollar, although the risk of a trend reversal is gradually increasing. As long as investors continue to anticipate further Fed interest rate hikes, the US currency should benefit from relatively high Treasury yields and capital inflows. However, increasingly weak consumer sentiment suggests that the resilience of the US economy could face a serious test.

In the medium term, the direction of the USD will depend primarily on whether persistent inflation continues to necessitate restrictive monetary policy or whether an intensifying economic slowdown prompts markets to begin pricing in interest rate cuts once again.