Today's edition of the Saxo Morning Call features the SaxoStrats team discussing the continuing weakness of the US dollar as commodity prices recover ground and in the wake of key US equity indices hitting all-time highs Thursday.
Article / 13 July 2017 at 2:14 GMT

Friday’s CPI update a crucial test for floundering USD

Managing Director / Technical Research Limited
New Zealand
  • Traders took a dovish take on Janet Yellen’s testimony
  • Both the headline and core CPI figure for June CPI should come in at 1.7%
  • The FOMC sees the policy rate reaching a hawkish 3% in two years time
  • Holding ground on inflation won't persuade markets to buy into the FOMC view
  • Structural factors may be at play in keeping US inflation low
By Max McKegg

Traders had been waiting all week for Federal Reserve Chair Janet Yellen’s appearance before the US Congress and were determined to use it as an excuse to spark some market action. Her testimony could be read both ways, but in the end traders settled on a dovish take, latching onto the sentence “It appears that the recent lower readings on inflation are partly the result of a few unusual reductions in certain categories of prices”.

Apparently this was the first time Yellen had said inflation shortfall was only “partly” due to transitory factors, the implication being the Fed suspects there are some structural factors at play as well. “There is, for example, uncertainty about when – and how much – inflation will respond to tightening resource utilization” said Yellen. In other words the time-honoured Phillip’s curve, which determines that inflation rises as unemployment falls, has become less reliable.

 Forex traders are finding it hard to buy into the FOMC’s hawkish projected path for the policy rate, and the USD dollar bears are back. Photo: Shutterstock

No surprise then that the Chair and her Federal Open Market Committee colleagues will be “monitoring inflation developments closely in the months ahead”. They, and the markets, will get first hand opportunity on Friday when the June Consumer Price Index numbers are released. Expectations are that the headline and core rate will both come in at 1.7% year-on-year which will help steady the ship after it swerved off course a couple of months ago.

US CPI, from 2000 to the present

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But just holding ground on the inflation front will not be enough to convince the market to buy into the FOMC’s hawkish path for the policy rate, which projects it will reach 3% in two years time. That is what Yellen calls the neutral rate – the level of the federal funds rate that is neither expansionary nor contractionary and keeps the economy operating on an even keel. The assumption is that the productive capacity of the US economy justifies a “real” rate of interest of 1% on top of inflation at the 2% target.

But there is uncertainly on the FOMC as to what the real rate should be. Committee member Lael Brainard said earlier this week that “In my view, the neutral level of the federal funds rate is likely to remain close to zero in real terms over the medium term. If that is the case, we would not have much more additional work to do on moving to a neutral stance”.

This uncertainly about how much more “additional work” needs to be done on rates is slowly filtering through into USD positioning which has turned negative for the first time since 2013.
USD speculators chart

Source: Bloomberg

The CPI numbers will have to beat forecasts to push the probability of another rate hike this year back over 50/50, give the USD some support, and see US Treasury yields resume their uptrend. EURUSD has been firmly correlated with the US versus Germany 10-year government bond spread but has been getting a bit ahead of itself in recent weeks, as shown in the chart below.

The gap in favour of Treasuries peaked at 235 basis points early this year but has since narrowed to 180 basis points. If the correlation is to hold – and justify the current level of EURUSD – bond yields in the US will need to fall while German bund yields hold steady (or rise). An under-par CPI number on Friday would do the trick.

EURUSD and yield spread

Source: Bloomberg

USDJPY has an even tighter correlation with US bond yields, reinforced last week when the Bank of Japan stepped in to hold the yield on the 10-year Japanese Government Bond under 0.10%. But that’s not to say Japanese investors just have to sit there and take. In a global context they have plenty of options, as shown in the global bonds table below. They can buy the 10-year US Treasury  – with the exchange rate rise eliminated (hedged)  – at a yield of about 0.70%, or even better, the German bund equivalent at 0.80%.

These “free lunches” mean there is no need for Japanese investors to be buying USD or EUR on an outright basis.

Global bonds hedged table

Source: Financial Times

Reading between the lines, there seems to be some second guessing at the Federal Reserve as to what’s going with inflation. Friday’s CPI numbers will answer some of their questions. The bond market reaction will determine the next move for the USD, in particular against EUR and JPY.

 – Edited by Robert Ryan

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Max McKegg is managing director of Technical Research Limited. Follow Max here or post your comment below to engage with Saxo Bank's social trading platform


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