Weaker US inflation provides trigger for another leg lower for USD

USD: Evidence of slower US inflation is becoming more compelling  

The US dollar has continued to trade close to year to date lows following yesterday’s sharp sell-off triggered by the release of the weaker than expected US CPI report for June. The dollar index hit a fresh year to date low of 100.42 after breaking below the previous low of 100.78 from April. In the process the dollar has extended its decline from last week’s high to around 3.0%. The Swedish krona (+5.6%) , Norwegian krone (+5.6%) and yen (+4.3%) have strengthened the most against the US dollar over this period marking a sharp reversal off the bearish trends that had been in place for most of this year. The Swedish krona has now fully reversed year to date losses against the US dollar while the yen and Norwegian krone still remain weaker. The main trigger the US dollar’s renewed downward momentum was the release of the US CPI report for June that provided further evidence that inflation pressures continue to slow. It has given market participants more confidence that the Fed is close to the end of their rate hike cycle. The Fed is still expected to deliver one more 25bps hike later this month but that is likely to be the final hike this year. We would even argue that one more hike is not really necessary. One more hike is not really necessary with the policy rate already restrictive at around 5.0%, and inflation set to slow further that will result in the real policy rate rising further into positive territory through the rest of this year. However, the Fed was already planning two further hikes this year making it likely that at least one will be delivered this month and more evidence of slowing inflation will be required to bring an end to hiking cycle. 

The latest CPI report revealed that the annual rate of headline inflation slowed to 3.0% in June as it moved further below last year’s peak of 9.1%. The slowdown in inflation is not just driven by lower energy and food prices, there is building evidence that underlying inflation pressures are slowing as well. The Fed has been focusing on the core services inflation measure stripping out housing costs (super core) to assess the risk of inflation persisting above their target. The good news from yesterday’s report was that the super core measure of inflation fell marginally in June by -0.004%M/M. The slowdown in super core inflation is not just a one off either, it was the third consecutive softer monthly print. The annualized rate of super core inflation has slowed to 1.4% in Q2 and 3.3% in the 1H of this year. It compares to an annualized rate of 4.7% in the 2H of last year. The developments give us more confidence that inflation will continue to slow in the coming months providing justification for the Fed to signal an end to their hiking cycle either at Jackson Hole in August or the September FOMC meeting. It is one of the key reasons why we have stuck recently to our outlook for further US dollar weakness in the 2H of this year (click here).         

SUPER CORE MEASURES OF US INFLATION ARE ROLLING OVER 

Source: Bloomberg, Macrobond & MUFG GMR

CAD: BoC delivers back to back rate hikes

The Canadian dollar has strengthened alongside other G10 currencies against the US dollar following the release of yesterday’s weaker US CPI report and the BoC’s hawkish policy update. It has resulted in USD/CAD falling back towards last month’s low at 1.3117. However, it has underperformed compared to other G10 currencies when it has been the second worst performing G10 currency after the US dollar. The performance of the Canadian dollar tends to be more tightly linked to the performance of the US dollar than other G10 currency pairs.

Yesterday’s developments have increased the likelihood that USD/CAD will fall further back below the 1.3000-level for the first time September of last year. While the weaker than expected US CPI report has dampened expectations for further Fed hikes beyond this month, the BoC’s policy update has left the door open to further hikes after delivering back to back 25bps hikes in recent months. It has been an abrupt hawkish turnaround from the BoC who had paused their hiking cycle between February and May. Governor Macklem delivered a clear signal yesterday that the BoC is prepared to hike again if needed although he also noted that the BoC is close to the end of their tightening cycle.

The decision to deliver back to back hikes was driven by the BoC’s concern that inflation is proving more persistent than expected. The updated inflation forecasts now show inflation falling back to their 2% target in the middle of the 2025 which is around two quarters later than forecast in January and April. The upward revision to the inflation forecast reflects three key factors: i) more persistent excess demand, ii) higher than expected house prices and iii) higher than expected prices for tradable goods. Canada’s economy has proven more resilient than expected during the first half this year. It has resulted in the forecast for  consumption to be revised higher by 0.4ppt to 1.5% for this year. The economy is now only expected to move into mild excess supply from the beginning of next year.

With the policy rate moving further into restrictive territory at 5.00% it should help to slow the economy more in the year ahead. It also increases the risk that BoC is overdoing policy tightening if the economy slows more sharply than expected as the lagged impact of tightening feeds through. The higher yields on offer are supportive for the Canadian dollar in the near-term until more convincing evidence begins to emerge of the negative economic impact of higher rates on Canada’s highly indebted households. It is why we are expecting the Canadian dollar to weaken over the next 6 to 12 months (click here).

SHORT-TERM DRIVERS MOVING IN FAVOUR OF LOWER USD/CAD

Source: Source: Bloomberg, Macrobond & MUFG GMR

KEY RELEASES AND EVENTS

Country	BST	Indicator/Event	Period	Consensus	Previous	Mkt Moving
UK	09:30	BOE Credit Conditions Survey	--	--	--	!!
EC	10:00	Industrial Production (MoM)	May	0.3%	1.0%	!!
EC	11:00	Eurogroup Meetings	--	--	--	!!
US	12:00	OPEC Monthly Report	--	--	--	!!
EC	12:30	ECB Publishes Account of Monetary Policy Meeting	--	--	--	!!
UK	13:00	NIESR GDP Estimate	--	--	-0.1%	!!
US	13:30	Initial Jobless Claims	--	249K	248K	!!!
US	13:30	PPI (MoM)	Jun	0.2%	-0.3%	!!!
US	23:45	Fed Waller Speaks	--	--	--	!!

Source: Bloomberg