Disinflation to cause the Fed to pause
Investors are gearing up for one of the most important rate decisions in recent time, as the Federal Reserve is expected to not increase its benchmark policy rate for the first time since starting the current tightening cycle 14 months ago. Yesterday’s weaker than anticipated CPI report has been the last shoe to drop before the FOMC meeting and has led markets to fully price out any possibility of a rate increase later today. This has put the Greenback marginally under pressure.
US inflation increased by less than expected in May, rising by 4.0% during the last twelve months and by 10 basis points on a monthly basis. Economists polled by Bloomberg beforehand expected headline inflation to come in at 4.1% y/y and 0.4% m/m. The downside surprise continues the string of disinflationary data releases and constitutes the 11th fall of headline inflation. While underlying price pressures, displayed by inflation excluding food and energy, marginally fell from 5.5% to 5.3%, the slump in other sticky components more than compensated for that, looking at the initial bullish repricing of stocks. The closely watched services inflation continued its descent as well, rising by 6.3% in May, after an 6.8% increase the month before.
The US dollar fell following the data release, as the implied probability of a rate hike in June decreased to less than 5%. However, given that a hike was already considered quite a tail risk to begin with, the downward pressure on the dollar remained limited. Furthermore, expectations about a July hike remain elevated at 60% and might limit the dollars descent, if Jerome Powell sets a hawkish tone at the press conference. EUR/USD briefly managed to rise beyond $1.08, but the Euro did not manage to finish the US session above the important level. The higher for longer narrative prevails for now, as hedge funds have increased their short exposure to 2-year Treasuries 11 weeks in a row.
Euro needs more than a cautious Fed
Inflation in Germany continues to cool. Wholesale prices in Europe’s largest economy fell for the second month in a row by 2.6% during the last twelve months. The slowdown has seen prices drop to near 3-year lows against the backdrop of falling commodity and agricultural products. While the data point is considered a secondary one and therefore not particular market moving, it adds to the narrative that consumer prices will fall more sharply than the European Central Bank currently projects.
The likely tightening pause by the Federal Reserve has so far overshadowed the importance of the upcoming ECB rate decision on Thursday. Markets are expecting European policy makers to raise rates two more times in June and July, concluding the tightening cycle after nine hikes at a deposit rate of 3.75%. Given high core inflationary pressures, this seems likely. However, with the Fed pausing and inflation continuing to cool, it will be hard to surprise the consensus to the upside when it comes to the policy path. It is more likely, that the ECB will have to cut rates sooner than is currently priced in, which is why the Euro has not been able to hold its gains after yesterday’s CPI report.
As we have noted before, the main force driving EUR/USD higher has been the anticipation of rate cuts by the Fed. These have now been priced out, leaving the Euro without a major catalyst in the short-term. For the currency pair to prosper going forward, policy easing bets would have to gain traction again, while the Chinese recovery speeds up. EUR/USD is trading once again below $1.08 with GBP/EUR moving around the €1.17 level
UK economy expands in April but trend less clear
The British economy has grown for two consecutive quarters, expanding by 0.1% in the last three months concluding March. Looking at the first month of the second quarter, gross domestic product rose by 0.2%, helped by a bounce back in retail and creative industries sectors.
The UK economy has now finally regained its pre-pandemic size but is struggling to gain momentum to reach the growth trend that was in place before 2020. The continued tightening of the Bank of England will likely put pressure in British households via increased costs of living and negative wealth effects through falling property prices.
The strong labor market report yesterday all but set in stone the next 25 basis point rate hike to 4.75% by the BoE later this month. Markets now price in an above 50% probability, that the BoE will have to hike rates to 6 % to fight 30-year high core inflation. The pound is still profiting from these monetary divergences favoring the Bank of England going into the Fed meeting.
Dollar recoups losses post CPI
Table: 7-day currency trends and trading ranges
Key global risk events
Calendar: June 12- June 16
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*The FX rates published are provided by Convera’s Market Insights team for research purposes only. The rates have a unique source and may not align to any live exchange rates quoted on other sites. They are not an indication of actual buy/sell rates, or a financial offer.
