Does the USD rebound have legs?

During the Asian trading session, the major foreign exchange rates have shown relative stability. The US dollar has remained below its intra-day high from Friday of 104.67. This is a result of the dollar's rebound this month, which began after the release of a strong NFP report on February 3rd. The next important resistance levels for the US dollar are at 105.00 and then the year-to-date high of 105.631.

Last week, the US dollar gained against the JPY (-2.1% vs. USD) and high beta commodity G10 currencies such as NOK (-1.3%), CAD (-1.0%), NZD (-0.9%), and AUD (-0.6%). However, the lower yielding European currencies such as the EUR (+0.2%), SEK (+0.1%), and CHF (-0.2%) held up better. Despite last week's price action being more consistent with risk-off trading conditions, global equity markets have remained resilient and have held onto year-to-date gains. MSCI's ACWI (All Country World Index) global equity index has increased by approximately 6.5% so far this year, although it has lost upward momentum in the first half of February.

Equity markets outside of the US have experienced a more evident loss of upward momentum, with MSCI's EM (Emerging Market) equity index correcting lower by approximately -5.5% from last month's high. It’s a setback for popular trades at the start of this year that had been anticipating that the US dollar and US equities would underperform as the US economy moved closer to recession.

The concerns of market participants regarding a more severe slowdown or recession in the US economy have eased in the near-term. This is due to the release of strong activity data that shows the ongoing resilience of the US labour market and US consumer at the start of the new year. In January, control retail sales rebounded strongly by +1.7%, making it the strongest month of sales since January of last year. However, this followed weakness in the final two months of last year that still indicates a clear slowdown in growth over the last three months. The Atlanta Fed's GDP Now forecast for Q1 has ticked up to around 2.5%.

The combination of stronger activity data and firm inflation data has raised the risk of higher inflation becoming persistent. This has fuelled expectations that the Fed will need to tighten policy much further beyond 5.00% this year. In recent weeks, the US rate market has fully priced in at least two more 25bps hikes at both the 22nd of March and 3rd May FOMC meetings. It has also moved to almost fully price in (+71bps) a third 25bps hike by the 26th of July FOMC meeting. As a result, market expectations for the Fed's terminal rate have risen to a new cyclical peak of around 5.30%, up from around 4.87% at the end of last month.

At the same time, the US rate market has become less confident that the Fed will begin cutting rates later this year. The implied yield spread between the August and December 2023 Fed fund futures contracts has narrowed sharply from around -36bps to -15bps as expectations for rate cuts have been pushed into next year.

In the upcoming week, the latest FOMC minutes from the 1st February meeting will be released and closely scrutinized to assess how close Fed officials are to changing their current plans to deliver a couple more rate hikes. This view was repeated recently by Fed Chair Powell after the release of the blowout NFP report for January. Last week, there were clear indications that more hawkish Fed officials have started to display greater concern again over upside inflation risks.

Cleveland Fed President Loretta Mester and St. Louis Fed President James Bullard both signalled that they are open to supporting further large 50bps hikes at upcoming meetings if required to get inflation under control. However, I do not expect that view to be shared widely among Fed officials and, more importantly, the main leadership. I still believe that two more 25bps hikes are the most likely outcome at the current juncture.

CPI & PPI

The US CPI and PPI reports, which were recently released, have indicated that the path to lower inflation will be challenging and that it will trigger bouts of market volatility and US dollar strength. While the US dollar is currently experiencing a rebound phase, it is expected to weaken further in the year ahead.

The US CPI and PPI reports provided evidence that inflation has been more persistent than expected at the beginning of the year, which should be confirmed by the release of the PCE deflator report in the week ahead. Headline inflation has rebounded strongly by 0.5% in January after a decline of -0.1% in December, and the trend toward weaker inflation prints remains intact. However, the annualized rate of headline inflation has slowed over the last seven months to 3.4% from a peak of 10.1% in June, moving closer to the pre-pandemic average rate of just over 2%. The Fed and market participants still want to see clearer evidence that underlying inflation pressures are easing. On their own, I don't expect the latest CPI and PPI reports to have altered the Fed's plans for a couple more 25bps hikes.

In these circumstances, we believe the US dollar’s recent rebound has room to run further in the near-term. A break above the 105.00-level for the dollar index would open a retest of the year to date high at 105.63 and then the 200-day moving average at just below 106.50.

I recommend you have a look at this post where I talk more in depth for a good opportunity on EURUSD: https://acy.com.au/en/market-news/market-analysis/looking-back-on-eurusd-151846 & in addition have a look at the Chart of The Day on YouTube https://acy.com.au/en/market-news/market-analysis/chart-of-the-day-eurusd-143347.

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