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Dollar slumps on cooling US inflation

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Written by:
Myrsini Giannouli

20 January 2023
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Important calendar events

  • JPY: National Core CPI
  • GBP: GfK Consumer Confidence, Retail Sales
  • USD: Existing Home Sales

USD

The dollar declined on Thursday on soft US inflation, with the dollar index dropping to 101.1. US Treasury yields also declined, with the US 10-year bond yielding approximately 3.4%. 

US unemployment claims on Thursday fell below expectations, providing support for the dollar. Unemployment claims dropped to 190K compared to the 214K predicted. The Philly Fed Manufacturing index released on Thursday was also more optimistic than expected printing at -8.9 for January, against expectations of a -10.9 print. Although a negative value denotes worsening conditions, the index showed improvement compared to December’s -13.8 print. 

US PPI data on Wednesday fell below expectations, driving the dollar down. Together with last week’s CPI data, the PPI indicators provide a more complete picture of the direction of US inflation. US inflation seems to be cooling, as Producer Price Index declined by 0.5% in December, versus estimates of a 0.1% drop. In addition, November’s PPI print was revised to reflect a 0.2% increase, instead of the original 0.3% to 0.2%.

US headline inflation dropped to 6.5% year-on-year in December from 7.1% in November. The soft inflation print has put pressure on the dollar, as cooling price pressures may give the US Federal Reserve some leeway towards scaling back its interest rate increases. 

Fed interest rate increases have been the main factor driving the US dollar and treasury yields over the past few months. At the latest monetary policy meeting the Fed raised interest rates by 50 basis points, bringing the benchmark interest rate to a target range of 4.25% to 4.50%. 

US economic outlook and inflation will likely determine the pace of future rate hikes. Many analysts believe that the Fed will ease its rate hikes but will continue raising interest rates at a slower pace until the benchmark interest rate reaches at least 5.0%. This means that there are likely still a couple of rate hikes up ahead, which may provide support for the dollar. Markets however are currently pricing in a more moderate 25-bp rate hike at the Fed’s next monetary policy meeting.

US Existing Home Sales are scheduled to be released on Friday and may cause volatility in dollar price. As interest in the Fed’s future policy direction mounts, the dollar will also be especially sensitive to FOMC members’ speeches this week.

TRADE USD PAIRS

EUR 

The Euro traded sideways against the dollar on Thursday, with EUR/USD oscillating around the 1.083 level. If the currency pair goes up, it may encounter resistance at 1.089 and higher near 1.118. If the EUR/USD pair declines, it may find support at 1.048. 

ECB President Christine Lagarde delivered a hawkish speech on Thursday at the World Economic Forum in Davos, bolstering the Euro. Lagarde emphasized the central bank’s commitment to raising interest rates to tackle soaring inflation. ECB Monetary Policy Meeting Accounts released on Thursday also provided support for the Euro. The accounts revealed the ECB’s commitment to raising interest rates, with many ECB members arguing in favor of a 75-bp rate hike at the previous monetary policy meeting.

Final EU headline inflation dropped to 9.2% year-on-year in December from a 10.1% print in November indicating that Eurozone inflation is cooling. This is the first drastic drop in inflation that signals that the ECB’s efforts to tame inflation bear fruit. Price pressures in the Eurozone remain high though, and interest rates need to rise significantly to combat entrenched inflation. 

EU inflation rates are still far from the ECB’s 2% goal and are forcing the central bank to hike rates aggressively. In its latest monetary policy meeting in December, the ECB raised interest rates by 50 bp, bringing its benchmark interest rate to 2.50%. 

The question, however, is whether economic conditions in the Eurozone will allow the ECB to continue raising interest rates at a fast pace. EU economic outlook is poor, and the ECB might be forced to raise interest rates in a recessionary backdrop.

Markets are pricing in at least two more 50-bp rate hikes in February and March this year. On the other hand, market odds for the next Fed rate hike are at 25-bp, as a pivot in the Fed’s policy is expected. If this scenario comes true, it will boost the Euro against the dollar. 

ECB President Christine Lagarde is due to deliver a speech at the World Economic Forum in Davos on Friday, which may affect the Euro.

EURUSD 1hr chart

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GBP 

The Sterling gained strength on Thursday, with GBP/USD climbing to 1.239. If the GBP/USD rate goes up, it may encounter resistance at 1.244, while support may be found near 1.184. 

Economic activity data on Thursday were overall disappointing, weighing down the Sterling. RICS House Price Balance dropped by 42% in December, indicating a rapid decrease in housing prices. 

On Monday, BOE Governor Andrew Bailey delivered a speech that was perceived as dovish, putting pressure on the Sterling. Bailey was optimistic about British inflation this year, stating that that inflation looks set to fall markedly as energy prices decrease. He stressed, however, that labor shortages in the UK pose a threat to cooling inflation rates. On Thursday, Bailey stated that a corner has been turned in UK inflation, appearing confident that inflation rates will continue to decline.

UK headline inflation dropped to 10.5% in December from 10.7% in November, in line with expectations. Core CPI, which excludes food and energy, remained at 6.3%, against expectations of a 6.2% print. The Sterling went up after the release of the CPI data as UK inflation has become entrenched, remaining firmly above 10%.

Surging inflation has forced the BOE to adopt a more hawkish fiscal policy, bringing its interest rate to 3.50% in December, its highest rate in 14 years. In the latest monetary policy meeting in December, BOE members voted to hike rates by 50 bps. With inflation remaining above 10%, this was perceived by many analysts as the start of a pivot toward a more dovish fiscal policy, putting pressure on the Sterling. 

The labor sector is ailing in the UK, but jobs data released on Tuesday were overall positive. UK monthly unemployment rate remained steady at 3.7% in November. The Average Earnings Index rose to 6.4% from the 6.2% expected, indicating that wages go up due to labor shortages. Conversely, Claimant Count Change, which denotes the change in the number of people claiming unemployment rose to 19.7K in December from 16.1K in November.

The UK’s grim economic outlook may limit policymakers’ ability to increase interest rates sufficiently to rein in inflation. The final GDP print for the third quarter of 2022 was -0.3%, indicating that the economy in the UK is shrinking. The British economy is still struggling, and policymakers will have to assess how much tightening it can withstand to bring inflation down. 

GfK Consumer Confidence and Retail Sales are scheduled to be released on Friday for the UK and may cause some volatility in the Sterling.

GBPUSD 1hr chart

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JPY

The Yen gained strength on Thursday as the dollar retreated, with USD/JPY touching the 128.3 level. If the USD/JPY pair declines, it may find support near 127.2 and further down at 114.2. If the pair climbs, it may find resistance at 138.2.

Trade Balance data for December on Thursday, showed a deficit of 1.72T, compared to the 1.60 T expected. This indicates that the cost of imported goods in Japan remains high, mainly due to import energy costs.

Japanese policymakers on Wednesday maintained ultra-low interest rates, keeping the central bank’s refinancing rate at -0.10% as expected. The Yen plummeted after the BOJ meeting, as markets were anticipating a pivot to a more hawkish direction. The BOJ was expected to further relax its yield curve control policy, but the central bank left all policy settings unchanged this month.

At the press conference following the BOJ meeting, BOJ Governor Haruhiko Kuroda defended the central bank's decision to keep its yield curve control policy unchanged. In addition, Kuroda vowed to conduct unlimited bond buying to maintain the bank’s yield curve control. Kuroda, however, is due to retire in April and his successor may decide to unwind the BOJ’s ultra-easy policy. A pivot in Japan’s monetary policy within 2023, would boost the Yen considerably. 

The BOJ caused a stir in markets in December by changing its yield control target for the 10-year government bond to between plus or minus 0.50%, from a previous 0.25%. The BOJ had set a target range around zero for government bond yields for years, and this adjustment may be the signal of a shift towards a more hawkish policy. Long-term, this move may allow interest rates to rise, cutting off some of its monetary stimuli. 

Price pressures continue to rise in Japan, as Year-on-year PPI to the end of December came in at 10.2% on Monday, exceeding expectations of a 9.5% print. In addition, BOJ CPI recently rose to 2.9%, mainly due to the high cost of imported energy. Inflation in Japan has gone above the BOJ’s 2% target, touching 40-year highs and putting pressure on businesses and households.

The final GDP Price Index for the third quarter of 2022 showed economic contraction by 0.3% on an annual basis and the Japanese economy shrank by 0.2% in the third quarter of 2022, mainly due to the high costs of imported energy. Japan’s economic outlook is poor, raising recession concerns for the world’s third-biggest economy.

National Core CPI data are scheduled to be released on Friday for Japan and might affect the Yen in the wake of BOJ’s decision on Wednesday.

USDJPY 1hr chart

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Written by:
Myrsini Giannouli

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