USD: Weakness may not last long
Yesterday’s US CPI read dealt a big blow to the dollar. Decelerating core inflation (0.3% month-on-month) surely represents an opportunity for the Federal Reserve to deliver a more convincing dovish pivot and soften its tone on the length/size of the tightening cycle. This is being reflected in the Fed Funds futures curve, which is now expecting only 50bp in December and a peak rate of 4.95% in 2023: a 30bp correction since last week.
We can now expect a period of elevated market sensitivity to Fed-speak, as investors will attempt to gauge which members have been convinced to press the breaks on tightening from the latest inflation figures.
In a market that was still quite extensively long, the dollar is seeing some sizeable position rebalancing. The oversold JPY and GBP were the best performers yesterday, while gains were more contained in EUR and CAD. Overnight, risk sentiment received an extra dose of support from the news that China is easing Covid-19 quarantine and flight restrictions. The renminbi is trading below 7.10 for the first time since September.
Still, we remain reluctant to jump in on the broader bearish dollar story just yet. First, because it simply appears too early to call victory in the inflation battle, and more evidence will need to come from the jobs markets – which has remained exceptionally tight. There may not be much interest from the Fed to switch to a more dovish stance without having gathered all possible data before the December meeting.
Second, there is still a lack of alternatives to the dollar at the moment. European currencies are benefitting from lower gas prices, but that has been due to mild weather, and concerns about the energy crisis for this and next winter are unlikely to abate over the next few months. In China, markets are welcoming looser Covid rules, but infection numbers are elevated and vaccination rates are low, which means that the path to complete removal of restrictions still looks long. Grim export numbers also pointed out how China’s strains are not only a domestic but also a global demand-related story. A heavy return to other EMFX currencies also appears premature given the worsening financial conditions and slowing global demand.
Third, risk assets are facing downside risks that go beyond the Fed story: from likely contracting corporate profits to housing market woes and, recently, the turmoil in the crypto market.
If nothing else, retaining defensive long dollar positions on the back of the incoming global recession and potentially more instability in risk sentiment would still look quite reasonable at this stage. In other words, the dollar peak might be past us, but a dollar downtrend may not be there yet. We remain moderately bullish on the dollar into year-end.
Today, the US bond market is closed for Veterans Day, while the stock market will operate as normal. Still, there could be some reduced trading volumes also in FX. The calendar includes the University of Michigan surveys (focus on the inflation expectation indices) and a speech by the Fed’s John Williams.
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