The market’s initial reaction to the 5.4% US inflation rate in June pointed to a wait-and-see attitude. The dollar index approached the resistance line of the trading range, however, it lacked the momentum to develop growth. Today the DXY is retreating from this month’s highs area at 92.8, and EURUSD is trying to get back above 1.1800.
Another indicator for market sentiment, the USDCNH, shows a subdued momentum after the renminbi rallied slightly at the end of last week.
The same is true for the stock market. The major US indices rewrote their all-time highs and retreated slightly from their peaks late in the day, maintaining a sluggish downtrend on Wednesday morning.
The very fact of the dollar strengthening and stocks weakening at the close of the US session suggests that fund managers are banking on the Fed’s increasingly hawkish rhetoric in response to an uptick in inflation.
This reaction is embedded in the reflexes of central bankers, but markets are quite sensibly pausing to clarify their position. There are reasons for this.
Since the global financial crisis, there has been chronically low inflation in the USA and several developed countries. It has become an obstacle for policy normalisation and was considered the norm even for periods of strong economic growth. This trend has recently been repeatedly referred to as the new normal, and so far, central banks are putting this scenario in their forecasts.
The second reason is the reaction of the debt markets. High inflation rates go hand in hand with falling long-term bond yields which contrast with the dynamics at the start of the year. At that time, rising inflation fears drove 10-year yields to a two year high. The debt market thus shows that long-term inflation expectations are under control as desired by the Fed.
There is still no significant pressure on the Fed to roll back stimulus despite the jump in inflation for the reasons stated above. For now, we still expect to hear official signals of an imminent QE rollback at the end of July or at the Jackson Hole symposium at the end of August. The surprise for us will be a dramatic tightening of the tone of the US central bank or Powell at a congressional hearing today or later in the week. This would then provide the necessary impetus to break the established trend and start a dollar rally.