Dollar rallies as US inflation surprises on the upside

Important calendar events

• GBP: RICS House Price Balance, BOE Credit Conditions Survey
• EUR: German WPI, Italian Industrial Production, Eurogroup Meetings, Main Refinancing Rate, Monetary Policy Statement, ECB Press Conference
• USD: PPI and Core PPI, Unemployment Claims

USD

The dollar rallied on Wednesday on hotter-than-expected US inflation, and the dollar index surged to the 105.2 level. US treasury yields also rose on diminishing Fed rate cut expectations, with the US 10-year bond yielding approximately 4.56%. 

US inflation surprised on the upside on Wednesday boosting the dollar. US Headline inflation rose by 3.5% year-on-year in March exceeding February’s 3.2% print and rising above expectations of a 3.4% print. Monthly CPI rose by 0.4% in March, against expectations of 0.3% growth. Core CPI, which excludes food and energy, also rose by 0.4% against the 0.3% growth anticipated. Inflation in the US has proven to be sticky, resisting the Federal Reserve’s efforts to bring it down to its 2% target. US PPI data on Thursday will provide a clearer picture of the direction of US inflation and are likely to affect the dollar as they may influence the Fed’s policy outlook.

The US Federal Reserve kept interest rates unchanged at its policy meeting in March, within a target range of 5.25% to 5.50%, as expected. The FOMC statement was optimistic about the state of the US economy and emphasized that disinflation is underway, although inflationary pressures remain high.

For months now, markets have been speculating on the timeline of the Fed’s pivot to a more dovish policy. Fed Chair Jerome Powell has stated that policymakers wish to see more evidence of disinflation before cutting interest rates. 

Market expectations of rate cuts dropped sharply after the release of the US inflation report on Wednesday. Odds of a rate cut in May are practically nil. Rate cut odds in June are down to 15% from 50% just a few days ago, while odds of a rate cut in July have dropped below 40%. Market expectations of rate cuts are becoming more moderate as policymakers have stated that they intend to start reducing interest rates slowly. Diminishing rate cut expectations are boosting US treasury yields, providing support for the dollar. 

Core PCE Price Index, which is the Fed’s preferred inflation gauge, rose by 0.3% in February compared to January’s 0.4% growth, which was in line with expectations.  On an annual basis, Core PCE dropped just below 2.8% in February, registering a marginal drop from January’s almost 2.9% print. Core PCE Price Index data showed that US disinflation is progressing, albeit slowly. 

The US economy remains robust and expanded by 3.4% in the final quarter of 2023, exceeding previous estimates of 3.2% growth. The US economy is expanding at a slower pace, however, as GDP data have shown expansion by 4.9% in the third quarter of 2023.

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EUR 

EUR/USD plummeted to the 1.074 level on Wednesday as the dollar surged. If the EUR/USD pair declines, it may find support at 1.072, while resistance may be encountered near 1.088.

This week the ECB monetary policy meeting on Thursday is expected to attract considerable market attention. The European Central Bank is widely expected to keep interest rates steady this month and market participants will focus mostly on the ECB’s forward guidance. 

The ECB kept interest rates unchanged at 4.50% at its latest monetary policy meeting. The EU central bank has revised its inflation projections down to an average of 2.3% in 2024, 2.0% in 2025 and 1.9% in 2026. In addition, the ECB has revised its growth projection for 2024 to 0.6%. Expectations of cooling inflationary pressures coupled with increased economic fragility, may induce the central bank to start cutting interest rates sooner than anticipated.

The ECB is expected to start cutting interest rates later this year since inflationary pressures in the Euro area are easing. ECB President Christine Lagarde has stated that policymakers wish to see more evidence of inflation dropping to the central bank’s 2% target. Lagarde said that they expect to have sufficient data in three months, pointing to a rate cut in June. The ECB is widely expected to start preparing the ground for a dovish pivot at Thursday’s meeting, pointing to a rate cut in June.

ECB policymakers were dovish in the past few weeks, expressing satisfaction at the rate of disinflation in the Eurozone and raising expectations of rate cuts in the following months. Market odds of a rate cut in June are at approximately 60%, while most market analysts forecast around 90 basis points of cuts this year. 

Headline inflation in the Euro area cooled to 2.4% in March from 2.6% in February against expectations of a 2.5% print. Core CPI, which excludes food and energy, dropped to 2.9% from 3.1% the previous month, versus 3.0% anticipated. Easing price pressures in the Eurozone may encourage the ECB to start lowering borrowing costs as early as June.

Flash GDP data for Q4 of 2023 showed that the Euro area economy was stagnant with a GDP print of zero, as anticipated. The Eurozone economy does not show sufficient signs of recovery and is on the brink of recession. The EU economy contracted by 0.1% in the third quarter of 2023 and barely expanded in the second quarter by 0.1%, after contracting by 0.1% in Q1. 

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GBP 

The GBP/USD rate dropped sharply to the 1.254 level later on Wednesday as the release of the US inflation report boosted the dollar. If the GBP/USD rate goes up, it may encounter resistance near 1.270, while support may be found near 1.250. 

The BOE maintained its official rate at 5.25% at its policy meeting in March but showed signs of preparing for a dovish pivot. BOE Governor Andrew Bailey’s statement after the meeting had dovish undertones, stating that cooling inflationary pressures in the UK support potential interest rate cuts and hinting at two or three rate cuts within the year.

Markets are pricing in the first BOE rate cut in June with approximately 60% probability, while a rate cut by August is considered almost certain. Rate cut expectations have become more moderate in the past months, with no more than 70 basis points of rate cuts priced in this year. 

The BOE has updated its inflation outlook, predicting that inflation will drop to the BOE’s 2% target in the second quarter of the year. If the BOE’s forecasts are realized, policymakers may be induced to cut interest rates sooner.  

British headline inflation dropped to 3.4% year-on-year in February from 4.0% in January, surpassing expectations of a 3.5% print. Annual Core CPI, which excludes food and energy, fell to 4.5% in February from 5.1% in January, against 4.6% forecast. 

The British economy has slipped into recession, contracting by 0.3% in the final quarter of 2023. Monthly GDP data for February due on Friday are expected to show that the British economy has narrowly avoided slipping into recession and has expanded by 0.1%. The British economy is fragile and may force the BOE to pivot to a more dovish policy.

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JPY

USD/JPY skyrocketed to its highest level since June 1990 on Wednesday, rising above the key 153 level. If the USD/JPY pair declines, it may find support near 150.8. If the pair climbs, it may find resistance near the psychological level of 154 and above that at a multi-decade high of 160.5.

Yen intervention concerns are high, as Japanese authorities have been warning repeatedly that an intervention to support the currency might be imminent. The Yen’s weakness is causing concern to Japanese officials who have been warning traders against speculative short selling of the Yen. 

Finance Minister Shunichi Suzuki and other Japanese officials have been issuing warnings to currency speculators repeatedly in the past couple of weeks, hinting at another intervention to support the weakening Yen. Japan’s Prime Minister, Fumio Kishida, has also stressed that excessive volatility in the Yen is threatening the country’s financial stability. Kishida warned speculators that officials will take appropriate action if there are any further excessive forex moves.

Japanese authorities have intervened to support the currency in the past and may do so again if the Yen continues to decline. Concerns about an imminent intervention have been keeping Yen short sellers in check, providing some support for the currency.

The BOJ pivoted to a more hawkish policy in March, ending its negative interest rate policy. The BOJ has been keeping interest rates at a negative level, putting pressure on the Yen. Japanese policymakers voted to raise the benchmark interest rate into the 0% - 0.1% range. 

The BOJ abandoned its ultra-easy monetary policy after almost eight years and performed its first rate hike in almost 17 years. The BOJ also abandoned bond yield curve control and dropped purchases of riskier assets. 

BOJ Governor Kazuo Ueda did not deliver clear forward guidance at his press conference after the meeting, stating that accommodative financial conditions will be maintained for the time being and did not give any hints of future rate hikes. In addition, Japanese policymakers are concerned about inflation not rising according to expectations. The BOJ’s 2% inflation target has not been met sustainably yet, which is likely to hinder policymakers from raising interest rates again soon. 

Ueda, however, hinted on Tuesday that the BOJ may be considering raising interest rates again in the next few months. Ueda stated that if inflation continues to rise in Japan, the BOJ will consider cutting down stimulus, raising expectations of another rate hike within the year. 

Even though the BOJ voted to raise interest rates, the Yen continues to weaken as there is still a significant disparity between interest rates offered by the BOJ and those from other major central banks. 

On the data front, inflation in Japan remains low but is slowly rising. Tokyo Core CPI rose by 2.5% year-on-year in February from 1.6% in January. Headline inflation climbed to 2.8% year-on-year in February from 2.0% in January. BOJ Core CPI, on the other hand, retreated to 2.3% year-on-year in February from 2.6% in January against expectations of 2.5%. 

Final GDP data for the final quarter of 2023 showed that Japan's economy expanded by 0.1% against expectations of 0.3% expansion. The Japanese economy contracted by 0.7% in the third quarter and expanded by 1.2% in the second quarter of 2023, showing that the country’s economy is shrinking. Recession concerns limit the odds of a BOJ hawkish pivot in the coming months.

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Written by:
Myrsini Giannouli

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