The Dollar's Quiet Strength Masks Deeper Market Divisions Ahead of FOMC Meeting

The dollar index rallied to its highest level in a month Friday, posting a +0.20% gain as markets reassessed the timeline for Fed rate cuts. The move came after a jobs report that painted a paradoxical picture: hiring cooled faster than expected, yet wage growth and consumer sentiment both surprised to the upside—mixed signals that left the door to rate cuts firmly closed, at least for now.

What caught traders’ attention wasn’t just the headline miss on payrolls (+50,000 versus +70,000 expected). It was the constellation of data points that tilted hawkish. November jobs got revised lower to +56,000 from +64,000. Yet unemployment fell to 4.4%, and crucially, average hourly earnings accelerated to +3.8% year-over-year, beating the +3.6% forecast. This wage-growth persistence told the Fed what it wants to hear: inflation isn’t going away quietly.

The University of Michigan consumer sentiment index backed this up, rising to 54.0 from expectations of 53.5. But here’s the kicker—consumers’ 5-to-10-year inflation expectations ticked up to 3.4% from 3.2%, signaling that longer-term price expectations are drifting higher. That’s the kind of data that keeps central bankers awake.

The FOMC meeting arithmetic is stark. Markets are now pricing in just a 5% probability of a -25 basis point cut when the FOMC convenes January 27-28. This complete repricing reflects not just Friday’s data, but a broader recalibration: the Fed is now expected to cut rates by roughly -50 basis points over the full 2026 calendar, down sharply from earlier expectations. Meanwhile, the Bank of Japan signals it will hold rates steady at its January 23 meeting despite upgrades to growth forecasts, and may add another +25 basis points through 2026. The ECB? It’s leaning toward unchanged rates for the year ahead.

This divergence is the dollar’s tailwind. A higher-for-longer rate environment in the US, combined with easier policy from other major central banks, creates the ideal conditions for dollar strength.

But there’s a shadow over this strength. President Trump’s plans to appoint a dovish Federal Reserve chair are circulating through markets, with Bloomberg reporting that National Economic Council Director Kevin Hassett tops the list of potential replacements. A dovish chair would signal easier monetary policy ahead—bad news for the dollar. Add to this the Fed’s December decision to inject $40 billion monthly in T-bill purchases to boost financial system liquidity, and the underlying tone for the dollar looks less convincing than the recent rally suggests.

EUR/USD tested a 1-month low Friday, sliding -0.21%, but the weakness was contained by bright Eurozone data. Retail sales rose +0.2% month-over-month (versus +0.1% expected), while German industrial production unexpectedly jumped +0.8% m/m after predictions of a -0.7% decline. These prints suggest the European economy isn’t in free fall, though ECB Governing Council member Dimitar Radev’s comment that current rates are “appropriate” signals no urgency for policy moves. Swaps show virtually zero odds for a rate hike at the February 5 ECB decision.

USD/JPY climbed +0.66% as the yen tumbled to a 1-year low against the dollar, after Bloomberg reported the Bank of Japan would leave rates on hold despite lifting its growth forecast. The yen faced a triple headwind: a stronger dollar, higher US Treasury yields, and mounting political instability in Japan after reports that Prime Minister Takaichi is considering dissolving the lower house of the National Diet.

Tokyo’s recent economic data painted a divided picture. November’s leading economic indicator rose to a 1.5-year high of 110.5, while household spending surged +2.9% year-over-year—the biggest six-month jump—confounding expectations of a -1.0% decline. Yet these bright spots couldn’t offset the yen’s structural headwinds: escalating China-Japan tensions over military-related export controls, defense spending set to reach record levels next fiscal year under a 122.3 trillion-yen budget package, and ongoing fiscal concerns that keep the Bank of Japan cautious about tightening.

Precious metals staged a sharp rally Friday, with February gold up +0.90% and March silver surging +5.59%. President Trump’s directive that Fannie Mae and Freddie Mac purchase $200 billion in mortgage bonds—effectively a quasi-quantitative easing move—injected safe-haven demand into gold and silver. The logic was clear: if the Fed is pursuing easier policy next year, precious metals as inflation hedges become more attractive.

That narrative gained further traction from persistent geopolitical risks spanning Ukraine, the Middle East, and Venezuela, plus ongoing uncertainty around Trump’s tariff agenda following the Supreme Court’s decision to defer ruling on their legality until January 29. If the Court strikes down the tariffs, the US budget deficit could widen sharply, and the dollar could face renewed pressure.

However, Friday’s dollar rally to a 4-week high worked against precious metals, and there’s another structural headwind: Citigroup estimates that reweighting of the BCOM and S&P GCSI commodity indexes could trigger outflows of roughly $6.8 billion from gold futures and a similar amount from silver positions over the coming week. The S&P 500’s climb to fresh record highs also pared safe-haven demand.

Yet central banks kept bidding. China’s PBOC expanded its gold reserves by +30,000 ounces to 74.15 million troy ounces in December—the fourteenth consecutive monthly increase. Global central banks collectively purchased 220 MT of gold in Q3, up +28% from Q2. Long positions in gold ETFs hit a 3.25-year high Thursday, while silver ETF longs reached a 3.5-year high on December 23, signaling that institutional demand for precious metals remains robust despite near-term headwinds.

The markets heading into the FOMC meeting appear to be pricing a hold, but beneath the surface, the real battle is between structural dollar strength—a function of rate differentials and fiscal divergence—and the longer-term risk that a dovish Fed chair appointment could flip that script entirely. That’s the tension traders are managing now.