Sticky US inflation boosts the dollar

Important calendar events

• GBP: RICS House Price Balance
• JPY: Core Machinery Orders, Revised Industrial Production
• EUR: Main Refinancing Rate, Monetary Policy Statement, ECB Press Conference
• USD: Core Retail Sales, Retail Sales, PPI and Core PPI, Unemployment Claims, Business Inventories

USD

The dollar gained strength on Wednesday, boosted by a hot US inflation print, with the dollar index climbing to 104.8. US Treasury yields were stable, with the US 10-year bond yield rising above 4.3%. 

Sticky US inflation provided support for the dollar on Wednesday. Consumer inflation is accelerating, with CPI rising by 0.3% in August from 0.2% in July against expectations of a 0.2% print. Headline inflation came in hotter than anticipated, climbing to 3.7% year-on-year in August from 3.2% in July versus 3.6% anticipated. Core inflation, which excludes food and energy, also rose by 0.3% in August from 0.2% in July. 

PPI data on the 14th will provide a more complete picture of the broader trend in inflationary pressures and are expected to cause volatility in dollar prices. Increasing price pressures may push the Fed to continue its hawkish policy until inflation drops closer to the Fed’s 2% target.

The dollar is expected to be driven in the next few weeks by Fed rate hike expectations. The U.S. Federal Reserve raised interest rates by 25 basis points in July to a target range of 5.25% to 5.50%, the highest level in 22 years. 

The Fed’s aggressively hawkish policy over the past year has been paying off and inflationary pressures in the US are easing. Most investors are anticipating a pause in rate hikes, but the US central bank has signaled that further tightening is possible if inflation does not go down consistently. Markets are expecting a pause in rate hikes this month but market odds of another rate hike in November are increasing.

Preliminary GDP for the second quarter of 2023 showed that the US economy expanded by only 2.1% against expectations of 2.4% growth. The preliminary GDP price index for the 2nd quarter of the year also came in below expectations at 2.0% versus 2.2% anticipated.

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EUR

EUR/USD declined on Wednesday, dropping to the 1.072 level. If the EUR/USD pair declines, it may find support at 1.068, while resistance may be encountered near 1.080. 

This week the attention of market participants will be focused on the ECB policy decision on the 14th. The ECB raised interest rates by 25 bp at its July policy meeting, bringing its main refinancing rate to 4.25%. The ECB begins a two-day meeting on Wednesday and will announce the interest rate on Thursday. The ECB rate decision this week is expected to affect the price of the Euro considerably since market odds are currently split between a pause in rate hikes and a 25-bp rate hike. 

Persistently high inflation may induce the central bank to raise interest rates again on Thursday. Deteriorating economic conditions in the Eurozone may force the central bank to dial down its tightening policy, though. Policymakers are currently divided and market expectations are equally divided between a pause and another 25-bp hike. 

ECB rhetoric was hawkish last week, boosting the Euro. ECB’s Peter Kazimir and Klaas Knot stressed that the central bank should raise rates further and that investors betting against an ECB rate hike would likely be in for a surprise. ECB President Christine Lagarde delivered a speech on Monday at an event hosted by the European Economics and Financial Centre, in London. Lagarde’s speech was non-committal on Monday, avoiding addressing the central bank’s rate decision next week. 

Final GDP data for the Euro area were disappointing, showing that the Eurozone economy expanded by only 0.1%, in the second quarter of the year, against expectations of 0.3% growth. The Eurozone economy barely expanded in the second quarter after contracting by 0.1% in Q1 of 2023. The EU economy is struggling and cannot withstand much further tightening. 

Flash CPI data for August showed that Euro Area headline inflation remained unchanged at 5.3% year-on-year against expectations of a drop to 5.1%. Core CPI, which excludes food and energy, however, dropped to 5.3% from 5.5% in July. Inflationary pressures in the Eurozone remain high, increasing the likelihood that the ECB will continue its policy of monetary tightening.

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GBP 

The Sterling was under pressure by week British GDP data on Wednesday. GBP/USD dropped to 1.244 after the release of the GDP figures but pared losses later in the day. If the GBP/USD rate goes up, it may encounter resistance near 1.264, while support may be found near 1.244. 

Britain’s economy contracted by 0.5% month-on-month in July after expanding by 0.5% in June. The prognosis was more optimistic, with markets forecasting a 0.2% decline in GDP. The state of the British economy is fragile, as prolonged tightening has taken its toll on the labor market and other vital economic sectors. The British economy weakened more than expected in July and this may play a decisive role in the BOE’s monetary policy decision next week.

The BOE raised interest rates by 25 basis points at its latest policy meeting, bringing the bank rate to a 15-year high of 5.25%. Market odds are in favor of another 25-bp rate hike in September followed by another in November.

High inflation in the UK is putting pressure on BOE policymakers to increase interest rates. Inflation in the UK is showing signs of cooling, demonstrating the effectiveness of the BOE’s consistently hawkish policy. Headline inflation dropped to 6.8% year-on-year in July from 7.9% in June. Core CPI, which excludes food and energy, remained steady at 6.9%. Even though inflationary pressures in the UK are easing, inflation is still high, and policymakers are likely to continue raising interest rates to bring it down. 

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JPY

The Yen extended losses on Wednesday and USD/JPY climbed to 147.7. If the USD/JPY pair declines, it may find support near 145.8. If the pair climbs, it may find resistance at 148. 

BOJ Governor Kazuo Ueda hinted on Monday that a policy shift may finally be on the horizon. In an interview with the Yomiuri Shimbun newspaper on Monday, Ueda admitted the BOJ will be exploring new policy options, if economic and price conditions continue moving upward. Ueda warned that the present ultra-easy policy will continue for some time but indicated that the BOJ is considering policy adjustments further down the track. 

Ueda’s unexpectedly hawkish comments boosted the Yen considerably on Monday. After a short reprieve, however, the Yen resumed its descent. Markets had time to digest Ueda’s comments by Tuesday and the Yen’s downfall continued on Wednesday. Even though Ueda hinted at a policy shift, a policy change is not imminent and will depend on future economic and inflation data.

The Yen has been weakening, pushed down by the BOJ’s ultra-accommodating monetary policy. The Yen’s weakness has been the subject of concern for Japanese authorities as it undermines the country’s importing potential and causes financial distress in households. 

Japanese authorities have been repeatedly warning speculators against excessive short-selling of the Yen. The Yen’s continued weakness is raising market awareness of another intervention by the Japanese currency to support the ailing currency. Many market analysts view the USD/JPY 150 level as the line in the sand for another intervention.

The BOJ has shown signs of relaxing its ultra-easy policy. The central bank maintained its short-term interest rate target steady at -0.10% at its latest policy meeting in July. The BOJ, however, has loosened its yield curve control. This will maintain the rate ceiling but effectively allow rates to float beyond the cap, allowing for rises by a further 50 basis points. 

National Core CPI dropped to 3.1% in July from 3.3% in June. Inflation in Japan has remained above the BOJ’s 2% target for more than a year, encouraging the BOJ to tighten its monetary policy. BOJ Core CPI dropped slightly to 3.0% in July from 3.1% in June. 

Final GDP data for the second quarter of the year showed that the Japanese economy expanded by 1.2%, disappointing expectations of 1.4% growth. The final GDP Price Index showed a 3.5% annual expansion, versus 3.4% the previous quarter. Japan’s economic recovery increases the odds of a hawkish pivot in BOJ’s monetary policy.

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Written by:
Myrsini Giannouli

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