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 / 26 November 2017 at 22:42 GMT

Inflation updates the key to USD index this week

Managing Director / Technical Research Limited
New Zealand
  • Inflation numbers are due out for the US, the Eurozone and Japan this week
  • PCE data on the US could have important implications for markets
  • A poor PCE number would give the FOMC cold feet about hiking rates
  • The FOMC’s neutral rate is falling into line with the bond market
  • The yield curve shape holds the key to US dollar

By Max McKegg

The most important items on the data calendar this week are the inflation updates out of the US, Eurozone and Japan. In each of these big three economies, GDP is expanding above potential and unemployment is below its natural level (at least in Germany, a proxy for the single currency bloc). Add very loose monetary conditions to the mix and you have the ideal ingredients for an inflationary brew. But so far the brew has failed the taste test.

Meanwhile the USD index is delicately poised and could break key support levels if Thursday’s US numbers fail to meet expectations, adding some doubt as to whether the Federal Reserve will go ahead with the much-anticipated rate hike on December 13.


The release of Personal Consumption Expenditures numbers on Thursday could have important implications for markets; PCE is the Fed's preferred measure of inflation. Photo: Shutterstock

The Eurozone is quickest off the mark with its price data and the numbers, also out Thursday, will be for the period ended November. The US and Japanese releases will be for October.

On an annual basis core inflation in the Eurozone is expected to have risen by 1.00%, a slight improvement on 0.9% the month before. Similarly, in Japan the consumer price index will probably have crawled up from 0.7% previously to 0.8% year-on-year. As traders aren’t expecting much, market reaction is likely to be muted in both cases. The glacial pace of improvement explains why monetary policy will need to remain very accommodative for the foreseeable future in those economies.

More important will be the price index of Personal Consumption Expenditures (PCE) out of the US, the Federal Open Market Committee’s preferred measure of inflation. The following chart shows the current situation: the annual rate of core inflation has been declining, reaching 1.3% in last month’s update. It’s no coincidence that both the US dollar and bond yields have also declined over the same period.

PCE chart (please click to enlarge)


Given the correlation between inflation, bond yields and the dollar (and the stockmarket a combination of all three), Thursday’s PCE numbers could have important implications for markets, not the least because a poor number would give the FOMC cold feet heading into their December 13 meeting.

Analysts expect the core rate to move up from 1.3% previously to 1.4% this time, probably just enough to hold the ship steady. But if we don’t see even this marginal improvement, markets will react negatively.

A lacklustre string of inflation numbers largely explains the flattening of the yield curve this year.

US yield curve

Source: Federal Reserve Bank of San Francisco

Another factor at play is a reassessment of the end point for the FOMC’s “normalisation” of monetary policy. As the following chart shows, back in 2011 consensus on the Committee was that the appropriate neutral rate of interest for the US economy was about 4.25%, comprising an inflation rate of 2% and a real rate of 2.25%. Since then, inflation expectations haven’t changed much but estimates of the neutral real yield have declined, largely in line with estimates of the potential growth rate of the economy.

The market seems to have been onto this long before the Fed, holding the yield on the 10-year Treasury bond well below the Fed’s estimate of the neutral rate. As the chart shows, the two rates are converging now as the Fed continues falls into line with the market. The FOMC’s updated assessment of the neutral rate will be published as part to their December 13 Summary of Economic Projections.

Fed neutral rate chart

Source: Bloomberg

Despite regularly lowering its estimate of the neutral rate, the FOMC has been tentatively raising its policy rate since December 2015. The market seems to less convinced they are on the right track, as demonstrated by a flattening of the yield curve.  A similar thing happened in 2004-2005. As shown in the chart below (click to enlarge), between June 2004 and the end of 2005, Alan Greenspan oversaw a rise in the fed funds rate from 1% to 4.25%.

But during this period the yield on the 10-year bond declined and didn’t start rising again until the Fed had completed its cycle. The then-chairman famously described this flattening of the yield curve as a conundrum (defined as “a confusing and difficult problem”).

Of course there is one big difference between now and then: the $2.5 trillion of bonds sitting on the Fed’s balance sheet, estimated to be holding long rates down by around 100 basis points. So, unlike Greenspan, new Fed chairman Jerome Powell could do something about it. He could steepen the curve by increasing the pace of balance sheet reduction.

US 10 year chart

Source: Metastock

The US dollar index declined when the Fed began raising rates in mid-2004, as shown in the chart below (click to enlarge), because higher rates at the short end were out-weighed by falling rates at the long end: the yield curve flattened. The dollar stayed under pressure until a year later when bond yields started rising faster than short rates. This curve steepening was the cue for USD to begin recovering. As the chart shows the index had regained all its losses by the time the tightening cycle had ended.

A similar situation is playing itself out this time around. The dollar index sold off when the Fed kicked off the current cycle in December 2015 and didn’t recover until the bottom was in on the 10-year bond yield in mid-2016. In a burst of enthusiasm the index then pushed up to a new high, prematurely as it turned out, because the bond rally sputtered out as inflation failed to take root. The yield curve started to flatten again and took USD down with it.

Therefore, it seems the shape of the yield curve holds the key to the next move in the USD index, not rate differentials at the short end, the traditional driver of FX rates. We see evidence of this with EURUSD pushing towards 1.20 when the US versus Germany two-year yield spread is close to 250 basis points, its highest level since 1999.

There’s been much discussion as to why the curve has resumed its flattening over recent weeks but the impact on the index has been clear: as shown in the chart, it is falling back to key support levels, forming a pattern similar to 2002.

One explanation for the curve flattening is that markets suspect core inflation in the US has already plateaued and could turn back down. Traders will show little tolerance if their suspicions are confirmed by a weak reading in Thursday’s PCE update. Bond yields will decline, flattening the curve further, taking USD down with it.

USD index chartnnn

Source: Metastock. Create your own charts with SaxoTrader; click here to learn more

– Edited by Robert Ryan

Max McKegg is managing director of Technical Research Limited. If you would like to receive Max’s Daily FX Trading Forecasts, then you are welcome to contact him (see Max's contact details under his biography on Trading Floor).


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