Dollar sell-off may not be Over and here is why
Equities kickedoff the week with a rally and greenback dropped another 1% as investors tend toprice in a bearish CPI report. The dollar index briefly fell below 108 points,the lowest level in a month. The flight of investors from the dollar comes despitecontinuing appreciation of Treasury yields - the yield to maturity of two-yearbonds rose to a new yearly high on Friday (3.57%), which may indicate apositive reassessment of economic prospects outside the US which is alwaysdollar negative. In other words, the demand factor for the dollar as adefensive asset could change sign :
The European currency is leading among major currencies in strengthening against the dollar, as ECB policymakers signal that markets may need to brace for more significant rate hikes, the next of which could occur as early as October. The head of the Bundesbank said in an interview over the weekend that if inflation remains unresponsive to the actions of the Central Bank, then the tightening will have to continue. However, the size of the increase will depend on incoming data, primarily on the dynamics of consumer prices. Nagel believes that EU inflation will peak at 10% by the end of the year.
At the same time, Fed officials are also not easing up on hawkish rhetoric. A number of policymakers on Friday attempted to communicate a hawkish message that the easing of inflation in August would not be a reason to slow down the pace of rate hikes. Waller, for example, said that if unemployment stays below 5%, then the response to inflation could be more aggressive. The official stressed, therefore, the importance of the data on the labor market. Amid hawkish rhetoric, two-year bond yields set a new yearly high on Friday.
Key for this week is the US inflation report due on Tuesday. The headline reading is expected to slow down to 8%, while core inflation, on the contrary, is expected to accelerate. In fact, this will be the most “favorable” combination for further aggressive rate hikes. Interest rate futures price in 75 basis point rate hike with a chance of 88%, so the bar to surprise the market with a hawkish decision should be high. A weak inflation report tomorrow could raise the chances of a 50bp outcome and a reduction of the expected interest rate differential between the US and the rest of the world may drive bigger dollar sell-off. Despite the rapid retreat of the dollar, the risks of a further move are skewed towards a downside. The key bearish goal may reside at the lower bound of the current bullish uptrend on the Dollar index (DXY):
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