Expectations of a declining headline CPI figure could drive the dollar lower, but traders should be aware of underlying trends that will limit any optimism
US inflation comes into focus
Today sees the US Bureau of Labor Statistics release their monthly CPI inflation data, with market clearly looking towards this report as the main event of the day. Inflationary pressures have understandably been the dominant force behind the dramatic pace of monetary tightening seen over the course of the year. However, with the past two months seeing the rate of inflation drifting lower, this week could enhance views that we are set for a protracted period of downside in price growth. The implications for such a phenomenon are obvious, with a swifter return towards target inflation allowing the Federal Reserve to reverse the course of interest rates and limit the economic damage that is caused by that policy. The chart below highlights how volatile energy has been over the course of the year, with the size of the moves in that sector highlighted by the June year-on-year energy CPI reading of 41%. The declines in crude and gas prices since those mid-year peaks have helped dampen the headline CPI figure, which fell from the June peak of 9% to 8.26% for August. This time around, markets are looking for a figure around 8.1%.
Unfortunately, we are yet to see any reversal in food prices, which has hit 11.3% growth according to last month’s reading. Meanwhile, the core CPI reading (excluding food and energy) hit a five-month high of 6.3% in August. That is forecast to rise once again this month, with markets predicting a number around 6.4%. Within that core number, it is important to track the shelter component, with that segment making up a whopping 32% of the entire CPI figure. That fact should not be lost on traders, as higher interest rates will likely drive housing costs upwards. Thus, traders should try to look into the breakdown to see just how these different elements are moving aside from the headline figure. As we have seen over the past week, energy prices are one area that the likes of OPEC are more likely to influence over the Federal Reserve.
Taking a look at inflation expectations, we can see that the recent decline in headline CPI has helped drive down the outlook for both near-term and longer term prices. This will undoubtedly be impacted heavily by the movement in energy prices given how volatile they have been.
Given the influence on central bank policy, the US dollar remains heavily correlated with inflation. The chart below highlights exactly that, with the rise in CPI raising expectations for higher rates and risk-off sentiment taking hold as a result. This relationship is also reliant on the fact that the dollar is perceived as a haven, with the likes of the Pound or Euro instead falling against the greenback despite their similar upward trajectory for rates. However, it is worthwhile noting that inflation has now seen two consecutive downward moves, with all eyes on today’s figure as traders expect a third. Does this mean we will see the dollar reverse lower? Perhaps over the near-term if inflation falls sharply. However, it comes down to expectations of whether we are truly on a trajectory that will bring a reversal in FOMC rates anytime soon. That seems unlikely, with the ongoing rise in key elements such as food and shelter bringing a strong underlying growth in CPI aside from the fluctuations in energy that can take the heat off the top end.
Looking at the dollar index daily chart, we can see that the greenback has started to come off somewhat as we head into the report. The uptrend is clearly defined, pointing towards further upside as long as we do not see a swift resolution to the economic troubles currently playing out. That seems highly unlikely, and the continued rise in shelter pricing will likely provide the underlying basis for continue above target inflation data. Nonetheless, short term downside could come if we see prices come off this month. However, with an ascending trendline underpinning the dollar index rise, we would ultimately require a break back below 109.90 and trendline support to bring about a fresh sell signal for this market. Until then, any short term downside would to provide a buying opportunity as more stubborn and entrenched inflation elements keep prices elevated.