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FX Update: US inflation reaction: follow through after the kneejerk?

Forex 4 minutes to read
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John Hardy

Head of FX Strategy

Summary:  The US October CPI data came in far hotter than expected at new multi-decade highs, jolting markets across the board as Fed rate hike expectations were brought forward. The US dollar strengthened across the board, and so did gold as real yields plunged on the market figuring that the Fed will remain behind the curve on inflationary risks. On that note, will the initial move higher in the US dollar eventually prove a red herring?

FX Trading focus: The proof in the USD kneejerk rally will be in the follow-through

A couple of things make me uncomfortable with the idea that the USD move can extend much higher from here – at least on the notion that the Fed will ever get serious on the hawkish side relative to other central banks. First, while further hot inflationary prints can yet get the Fed to shift its guidance for a faster taper pace already at the December 15 FOMC meeting (we get the November jobs and CPI report and the October PCE inflation data before then) the Fed is unlikely to “get ahead” of inflation and is instead more likely to stay behind the curve, certainly relative to other central banks that are moving more rapidly to address rising inflation risks, even if the ECB and BoJ will always try to lag, but have the tailwind of current account surpluses.

Rather, any further move higher in the US dollar in the near term would far more likely be down to reduced liquidity and weak risk sentiment in global markets rather than a accelerated pace of Fed tightening. The still low yields at the long end of the US yield curve (despite yesterday’s chunky move in the wake of the very bad 30-year T-bond auction and the prior day’s weak 10-year auction) do indeed suggest that something is amiss with the US Treasury market. Are these low yields really a rational assessment of concerns that the forward growth outlook is dire, with near term inflationary outcomes eventually leading to a sharp tightening that kills growth? Or are they simply a reflection of poor liquidity and dysfunction in the world’s most important financial asset – US treasuries? Indeed, Bloomberg ran an article on this very topic in late October (linked to wild volatility at the short end of the curve) and I found a small update on the Bloomberg platform this morning that their measure of liquidity in the bond market is the worst for the cycle. Would not a more aggressive tapering of QE help to ease the liquidity concerns and help improve liquidity and are the odd developments in the US yield curve of late perhaps linked to massive macro bets on yield curve steepening gone awry?

Bottom line: The “Fed catching up” narrative doesn’t work for me as a driver of notable further USD strength, and further USD strength from here for any reason, including the possible one noted above, rapidly becomes destructive and  something that must be addressed – via a Plaza Accord-type arrangement if the Fed can’t restrain the USD from strengthening – although we’re not quite at that pain level any time soon.

As noted in this morning’s Saxo Market Call podcast, the most interesting move yesterday was in the gold price, which soared through resistance despite longer yields rising yesterday, as inflation fears accelerate more rapidly, dragging real rates lower – that is an interesting macro signal, to the say the least, and the JPY weakening despite the sharply lower US real yields is likewise interesting if it can be sustained. Worth noting yesterday that the Kishida government announcing plans to offer cash stimulus for lower-income households to the tune of JPY 100k (just under $900) in a plan that will cost “tens of trillions of JPY”. JPY 10 trillion is about $88 billion, or about 1.8% of Japan’s GDP.

EURUSD dumped through the lows and through the psychologically significant 1.1500 level all in one swoop yesterday as hot US inflation data made its mark. The next level of import is the 1.1290 area, the 61.8% retracement of the rally from the post-pandemic lows as the US dollar is now in a new rally phase until proven otherwise with this move. Of course, a rapid reassessment of the break and rally back above 1.1550 or so is all that it takes to reject this latest development.

Source: Saxo Group

Table: FX Board of G10 and CNH trend evolution and strength
The USD and especially CNH strength stick out here, but notice that the most prominent development of late has been the surge in gold prices, especially given the strong US dollar.

Source: Bloomberg and Saxo Group

Table: FX Board Trend Scoreboard for individual pairs
The US dollar strong enough that one of the last holdouts – the Swiss franc – is falling against the  weight of the stronger US dollar. Elsewhere, note the struggling commodity currencies as gold trend readings intensify.

Source: Bloomberg and Saxo Group

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