High flying USD pares gainsAs U.S. GDP unexpectedly shrinksBut this looks like a blipAnd won't shake the Fed

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The U.S. economy unexpectedly shrank in the first quarter, prompting a pullback in the high-flying U.S. Dollar, but any weakness is still viewed as temporary with economists saying the economy should return to health growth.

The Dollar pared fresh multi-month highs against the Pound and multi-year highs against the Euro on news the U.S. economy contracted 1.4% quarter-on-quarter in the first quarter.

The market was expecting the economy to expand 1.1% on the quarter.

"The U.S. dollar surrendered some strength following sobering news on first quarter growth," says Joe Manimbo, Senior Analyst at Western Union Business Solutions.

The Dollar index - a broad measure of the currency according a basket of USD exchange rates - was seen steadying just below multi-year highs at 103.80 in the wake of the numbers.

A powerful GBP/USD sell-off was meanwhile arrested near 1.2436, with the EUR/USD consolidating at 1.04. (Set your FX rate alert here).

Above: The downtrend in GBP/USD (top) and EUR/USD (bottom) remains strong.

"The surprise contraction in growth left the dollar ripe for some profit-taking after its incredible burst of strength this week," says Manimbo. Earlier, "the U.S. dollar bulldozed its way to fresh 5-year highs as it remained the currency of choice in the face of rising worries about global growth".

Certainly, it is however too early to call an end to the Dollar's advance and foreign exchange markets will remain alert to further gains.

A looking into the details of the GDP release reveals no major cause for concern regarding the outlook; indeed final domestic demand was still healthy growing at 2.6% pace and consumer spending increased 2.7% on the quarter.

"Where the economy faltered was in the production of goods," says economist Avery Shenfeld at CIBC Capital Markets.

"That was led by accelerating business investment spending, a sign of confidence about demand ahead that is consistent with the eagerness to add workers," he explains.

It is noted a surge in imports acted as a drag on GDP as businesses replenished stocks, aided by improvements in global supply chains during the quarter.

"The fall in GDP is not nearly as bad as it looks," says Daniel Vernazza, Chief International Economist at UniCredit Bank in London. "This is because the big detractors from GDP in 1Q22, net exports and inventories, are also the most volatile components and are likely to improve in coming quarters."

It is noted that with inflation running hot consumers appear to be funding consumption by dipping into savings accumulated during the pandemic.

But "at some point, Americans will start to pare back demand unless prices start to come down again," says Shenfield.

Nevertheless, CIBC Capital Markets expect a return to healthy growth over the next couple of quarters, with net trade and inventories unlikely to be nearly as big a negative,

Crucially for the Dollar outlook, the Federal Reserve are unlikely to be swayed by the GDP disappointment.

Inflation is running hot and they will look through the data and opt to raise interest rates by 50 basis points at upcoming meetings.

This should provide Dollar exchange rates with ongoing yield support.

"Today’s GDP report does nothing to change our view for the Fed; indeed, the 8% annualised surge in the GDP deflator in Q1 served to underline the ongoing and significant challenge of high inflation the Fed faces. We continue to expect 50bp rate hikes in May and June, with the Fed hiking in 25bp steps thereafter," says Bill Diviney, an economist at ABN AMRO.