Dollar Drops on the Disinflation Trade – Keep Selling?

The downside surprise in US June CPI inflation has seen the dollar drop to new lows for the year. Over recent months I had been speculating that clear signs of US disinflation - and a weaker dollar - may emerge in 3Q23 and yesterday's moves could well be the start of an important market adjustment. 

USD: The start of something 

Wednesday’s release of the US June CPI numbers suggests a significant shift in the direction of Fed rate hikes. After a prolonged period of anticipation, these surprisingly soft figures indicate that the sharp rate hikes may finally be taking effect. James Knightley, US economist, highlights the welcome declines across all major categories of inflation. While he believes another 25bp Fed rate hike will still occur at the upcoming meeting on 26 July, these CPI numbers lend support to the notion that this might mark the end of the rate hike cycle. Moreover, this data could signal a change in the Fed's narrative, shifting from frustration over slower-than-expected inflation decline to a more positive reception of recent data releases.

I’ve already discussed the potential impact of a weak US CPI print on the foreign exchange market. As expected, the soft CPI numbers have influenced pricing globally, leading to a bullish steepening of yield curves, higher equity prices, narrower credit spreads, and a weaker dollar. The current FX price action reflects a position unwind, with currencies that were sold under a bearish/hard landing scenario (such as Norway's krone, Sweden's krona, and to a lesser extent, some other commodity currencies) making a strong comeback. Notably, both the NOK and SEK were undervalued in my medium-term valuation models and are now experiencing a recovery.

This may mark the beginning of the long-awaited cyclical decline for the US dollar. While there are similarities to the dollar sell-off observed in November and December of the previous year (which resulted in an 8% decline over two months), there are two significant differences this time. First, speculators are not as heavily invested in long positions on the dollar as they were in October last year. Second, the growth stories of China and Europe do not appear poised for as significant a re-rating as they experienced in November.

For now, I maintain a bearish outlook on the dollar trend, with the DXY index potentially testing significant psychological support at 100.00. A breakout could lead to a target of 99.00. 

EUR: 1.1275 is the next target for EUR/USD

The recent soft inflation data in the United States has had a positive impact on pro-cyclical currencies, including the euro. As a result, the EUR/USD pair is trading comfortably at new highs for the year. It is currently retracing the decline it experienced between 2021 and 2022, with the next technical target being 1.1275. Today, it would be wise to pay attention to the account of the European Central Bank (ECB) meeting held on 15 June. It is expected that the ECB will not see any advantage in attempting to mitigate market expectations of two additional 25bp rate hikes this year.

On a different note, I have observed EUR/CHF breaking down to new lows. However, it may not be prudent to pursue further downward movement aggressively, as the Swiss National Bank (SNB) will likely achieve much of their desired appreciation in the nominal trade-weighted Swiss franc due to the significant decline in USD/CHF.

GBP: Cable up, EUR/GBP sideways

There is a noticeable correlation among short-dated yields worldwide, particularly evident when considering the impact of yesterday's soft US CPI data. This data led to a reduction of 22 basis points in the projected tightening cycle of the Bank of England for early next year. Yesterday's financial stability report from the Bank of England, along with subsequent communications, conveyed the message that consumers and businesses would be able to withstand higher interest rates if they were to materialize. 

In some respects, the British pound has already experienced a re-rating based on the hawkish stance of the Bank of England, which may limit its outperformance during the current phase of dollar weakness. Nonetheless, many investors are now setting their sights on a GBP/USD move towards 1.3300, provided that we can maintain a weekly close above 1.30.

As for EUR/GBP, it has rebounded from its recent low near 0.8500, which could potentially mark the lower boundary of the trading range for this quarter.

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