Dollar rallies ahead of US inflation report

Important calendar events

• JPY: BSI Manufacturing Index, PPI
• EUR: German Final CPI, ECOFIN Meetings
• GBP: Claimant Count Change, Average Earnings Index, Unemployment Rate, CB Leading Index
• USD: NFIB Small Business Index, CPI and Core CPI, Federal Budget Balance

USD

The dollar rallied on Monday, with the dollar index climbing to the 102.9 level. US treasury yields also gained strength, with the US 10-year bond yielding approximately 4.10%. 

The US Federal Reserve kept interest rates unchanged at its meeting in January, within a target range of 5.25% to 5.50%. The Fed has removed the tightening bias from its policy statement, indicating that the central bank is preparing to pivot to a less restrictive monetary policy. Fed Chair Jerome Powell, however, has discounted the possibility of a rate cut in March. 

Fed Chair Jerome Powell delivered a speech last week that was more dovish than anticipated. Powell stated that policymakers are close to acquiring confidence that inflation will continue to drop sustainably, which is required to start reducing interest rates. Powell’s speech drove the dollar to its lowest level since the start of the year and put pressure on US treasury yields.

Fed officials wish to see more evidence of disinflation before moving ahead with cutting interest rates. Odds of a rate cut in March are practically nil. Rate cut odds in May are also down to 20% from over 80% a few weeks ago. In addition, only 25 basis points of rate cuts are priced in by May, against 25-50 bp before. Market expectations of rate cuts are becoming more moderate as policymakers have stated that they intend to start reducing interest rates slowly. 

On the data front, Core PCE Price Index, the Fed’s preferred inflation gauge, rose by 0.4% in January compared to December’s 0.2% growth.  On an annual basis, Core PCE was at 2.8% in January, down from 2.9% in December. Core PCE Price Index data showed that US disinflation is progressing, albeit slowly. 

Preliminary US GDP data showed that the US economy remains robust and expanded by 3.2% in the final quarter of 2023, missing, however, market forecasts of 3.3%. The US economy is expanding at a slower pace, as final GDP data have shown expansion by 4.9% in the third quarter of 2023, but economic growth in Q4 of 2023 exceeded expectations. 

US Headline inflation rose by 3.1% year-on-year in January from a 3.4% print in December against expectations of a much lower reading of 2.9%. Monthly CPI rose by 0.3% in January, exceeding expectations of a 0.2% print. Core CPI, which excludes food and energy, rose by 0.4%, its higher monthly growth since June, against expectations of a 0.3% raise. 

Markets were anticipating a sharp drop in inflation in January, which was not realized, dashing expectations of early Fed rate cuts, and boosting the dollar. The progress of disinflation in the US is not steady, limiting the odds of a Fed rate cut before June.

This week, markets are likely to focus on the US inflation report on the 12th. February’s inflation report may show another monthly increase and can potentially set back the Fed’s plans to reduce interest rates. February’s CPI is forecast to rise by 0.4% monthly, which will keep annual inflation steady at 3.1%. Core CPI is seen rising by 0.3%, which will bring the annual rate lower at 3.7%. A lower-than-expected inflation print may raise rate cut expectations, boosting the dollar.

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EUR 

EUR/USD edged lower on Monday, dropping below the 1.093 level. If the EUR/USD pair declines, it may find support at 1.079, while resistance may be encountered near 1.093.

The ECB kept interest rates unchanged at 4.50% at its monetary policy meeting last week. 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 down 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.

ECB President Christine Lagarde has stated that the ECB wants to see more evidence of inflation dropping to the central bank’s 2% target. Lagarde said that policymakers expect to have sufficient data in three months, pointing to a rate cut in June, while most market analysts forecast around 90 basis points of cuts this year. 

On the data front, headline inflation in the EU dropped to 2.6% year-on-year in February from 2.8% in January. Euro area inflation, however, missed expectations of a greater drop to 2.5% in February. Core inflation, which excludes food and energy, has dropped to its lowest level in two years. Core inflation cooled to 3.1% in February from 3.3% in January, but also disappointed expectations of a drop to 2.9%.

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. 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 

GBP/USD retreated on Monday, dropping to the 1.280 level. If the GBP/USD rate goes up, it may encounter resistance near 1.300, while support may be found near 1.259. 

Britain's Spring budget was announced last week boosting the Sterling. British Finance Minister Jeremy Hunt is tasked with striking a balance between boosting economic growth and managing high inflation. Hunt announced that he would cut the rate of social security contributions by 2%. Hunt was hoping to announce tax cuts to the British public to boost the appeal of the Torry party ahead of the General Elections at the beginning of next year. Budget constraints, however, have left the British Finance Minister little room to maneuver with.

The BOE maintained its official rate at 5.25% at its latest meeting, as expected. In addition, the BOE updated its inflation outlook, predicting that inflation will drop to the BOE’s 2% target in the second quarter of the year. This reinforced the notion that the central bank is preparing to cut interest rates. BOE Governor Andrew Bailey has stressed that inflationary pressures are cooling and that further rate hikes are not required. 

Market expectations of BOE rate cuts are putting pressure on Sterling. Markets are pricing in the first BOE rate cut in June with approximately 50% probability, while a rate cut in 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 within the year. 

The British economy remains fragile and may force the BOE to pivot to a more dovish policy. Recent GDP data showed that the country has slipped into recession. Monthly GDP contracted by 0.1% in December, from a 0.2% growth in November. Preliminary quarterly GDP data revealed that the British economy contracted by 0.3% in the final quarter of 2023, against expectations of 0.1% contraction and 0.1% contraction in the third quarter of 2023. The British economy expanded by 0.3% in the first quarter of the year and 0.2% in the second quarter. 

British headline inflation remained steady at 4.0% year-on-year in January, against expectations of a 4.1% print. Annual Core CPI, which excludes food and energy, grew at the same pace of 5.1% as December and November, against the 5.1% forecast. British inflation is expected to fall towards the BOE’s 2% goal in the coming months, relieving some of the pressure on the central bank to keep high-interest rates. 

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JPY

USD/JPY traded sideways on Monday, oscillating around the 146.8 level. If the USD/JPY pair declines, it may find support near 146.2. If the pair climbs, it may find resistance near 150.8.

The BOJ kept all policy levers unchanged at its January meeting, maintaining its ultra-easy monetary policy. The BOJ has been keeping interest rates at a negative level, putting pressure on the Yen. The BOJ has so far maintained its dovish bias as other major central banks, and especially the Fed, have raised interest rates to high levels. BOJ Governor Kazuo Ueda has hinted at a policy shift down the road but has remained non-committal regarding the timeline of a potential rate hike.

An immediate policy shift is not expected yet, but markets are pricing in the first BOJ rate hike in June with a lower probability of a rate hike in April. Only a small rate hike of 10bps is considered likely, which would bring the BOJ’s interest level from negative to zero. Last week, however, reports that BOJ members would speak in favor of a rate hike at the next policy meeting in March, raised rate hike expectations, boosting the Yen. 

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, according to data released on Tuesday. BOJ Core CPI remained at 2.6% year-on-year in January against expectations of 2.3% print. In addition, headline inflation rose by just 2.0% year-on-year in January from 2.3% in December. 

Final GDP data for the final quarter of 2023 on Monday fell below expectations, putting pressure on the Yen. Final GDP data showed that Japan's economy expanded by 0.1% against expectations of 0.3% expansion. Monday’s data, however, were more optimistic than the preliminary GDP data released a month earlier, which had shown a 0.1% contraction in Japan’s economy. 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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