FX Update: US CPI to set the tone for FOMC and USD.

Today's Saxo Market Call podcast

FX Trading focus:

• USD on its back foot as risk sentiment continues to soar – US CPI later today the obvious focus, but will the Fed’s “third mandate” (the S&P 500) play any role in tomorrow’s decision?
• UK labor market data comes in strong, with sharply improved revisions of key April numbers.

Trading and bias notes:

• USD: Two-way risks in the coming two days. On a soft CPI print and the Fed delivering a pause, we likely have room for USD to test significantly weaker – for example, EURUSD toward top of range. A hot core CPI print and Fed rate hike could be felt most strongly in USDJPY, especially if BoJ holds off from even hinting at anything on Friday.
• NOK: EURNOK backing up on weak Q1 Norway GDP report. After recent reversal, bears in EURNOK in charge as long as the price action stays south of 12.00
• GBP: Very choppy – traded to local highs yesterday on rhetoric from BoE’s Catherine Mann before significant consolidation lower – back higher today on strong labor market data.
• JPY: lurking in the background is the Friday BoJ meeting – even guidance for an eventual tweak to the tightening side could drive significant volatility/JPY upside, with the scale of that volatility dependent on whether Fed pauses or hikes.

Hot UK labor market data this morning pumps UK yields to new cycle highs.
Some very positive revisions to ugly April UK labor market data have changed the plot here again for the Bank of England. The Payrolled Employees figure was inline at +23k for May, but the strong revisions to April data, from original –136k up to +7k wiped away concerns, even if the moving average is still trending in the wrong direction. More good news was in the May Jobless Claims numbers, which fell –13.6k, while April figures there were revised down to +23k from what was originally a two-year high of +47k. The April Employment Change figure (3-months/YoY) was +250k, a new high since May of last year, while the April Unemployment rate dropped to 3.8% from 3.9% and versus 4.0% expected. Average Hourly Earnings for April were far higher than expected, at +7.2% ex Bonus YoY vs. 6.9% expected and 6.8% in March. This mix of data jolted the UK 2-year yields another 18 basis points higher to new highs above the chaotic period last fall during the Kwarteng-Truss mini-budget debacle. GBPUSD revived on this, but much of that was a weaker USD, and it is interesting to note the weak transmission of higher UK yields into sterling as measured by EURGBP today, which is flat to slightly lower today after rallying sharply yesterday from new lows (on BoE Catherine Mann voicing concerns on sticky inflation).

Today’s US CPI sets up the FOMC tomorrow
Today’s US CPI looks set to drive significant volatility as risk sentiment is in near melt-up mode coming into today’s release (Warning: we have significant US equity market intraday volatility risk on so-called zero-days-to-expiry options that can risk driving wild swings in the intraday action in both directions. Extremely short data options have driven new patterns in intraday volatility and some considerable volatility events outright: most impressively on the December 13 release of the surprisingly soft CPI November CPI, which saw the market rally some 3% and then deflate back to unchanged all within a few hours). Was yesterday’s odd combination of a strong rise in the market and a large rise in the VIX a sign that market participants are loading up on short-dated options. I only bring this up because asset markets move in synch on volatility inducing events, so it may be necessary to keep a cool head in the event of a surprise in the data. Given strong sentiment and the market’s assessment that odds are low for a hike tomorrow, the more impactful “surprise side” could be in hotter-than-expected core inflation – anything above the 0.4% MoM expected. And even if we get an in-line to soft print, we have to be wary that some of that is already in the price.

As well, if we see a softer than expected core US CPI print today and the market continues to melt-up, could the action raise Fed concerns on the financial stability front, the so-called “third mandate” for Fed policy? I wouldn’t care to quantify that risk, but a wild market rally after the Fed has carried out its largest rate hike cycle in decades must sit poorly with the Fed here on the weakness of its policy transmission.

Chart: EURUSD
EURUSD faces an important test in coming days on the US CPI release today and then the FOMC tomorrow and ECB meeting Thursday. The latter is surrounded with little anticipation on the recent weak European activity data. The pair will most likely be driven by USD direction, therefore, more than EUR direction. A weak US CPI print today and a Fed move to pause could set us back on the path to 1.1000 and higher, while any hot core CPI release today and a Fed decision to move tomorrow rather than waiting for July could have us testing the recent lows below 1.0700 again. The volatility may not stop if Friday sees any hawkish surprise from the Bank of Japan, which could punch the USD lower broadly if the Fed has paused ahead of this meeting, and perhaps even if it hasn’t. Bank of Japan surprises will have the most impact this week.