The dollar sinks as inflation is digested and earnings season is awaited
The US inflation report is still dominating financial markets on Thursday. US inflation data for March showed a worrying crossover. Core CPI, or sticky inflation, is now higher than headline inflation. Headline inflation is 5%, while core CPI is 5.6%. Headline inflation has fallen back as energy prices have tumbled and food prices have stabilised, however, core CPI is continuing to rise, largely due to rising shelter costs, which rose 0.7% month on month in March, airline fares and car insurance costs. Core CPI is called sticky inflation for a reason: it tends to stick and it's very hard to lower. Thus, while 2022 was all about headline inflation, 2023 will be centred on the Federal Reserve’s fight against core inflation.
Is the dollar a spent force for 2023?
The reaction to the inflation report has been interesting. In the G10 FX space, the dollar is sinking yet again, EUR/USD has risen through $1.10, a key psychological level, with people now talking about a rise to $1.15. GBP/USD is also rising, and is above $1.25, could $1.30 be on the cards? We know that when it comes to FX, momentum matters, and right now, momentum towards the dollar is on the downside. The dollar index is at its lowest level for a year, and is currently 0.8% lower on the week, and -2.48% lower YTD. Thus, downside momentum is speeding up, which suggests that there could be further downside for the greenback in the coming weeks. If the dollar index breaks below 100.00, it is currently trading at 100.93, opens the way to 95.00, the weakest level since the end of January 2022.
The Fed: hike in May and then go away
While the dollar has sunk, Treasury yields have been more stable, after falling earlier in the Thursday session, the 2-year yield has climbed higher and is back at 3.97%. The Fed Fund Futures market, which measures expectations about where US interest rates will go next, is still predicting a more than 65% chance of a rate hike from the Federal Reserve next month to 5-5.25%. Thus, the market still thinks that the Fed will hike rates, although further out the curve, the market is expecting a faster pace of interest rate cuts. The Fed Funds Futures market expects interest rates to fall to 4-4.25% by January 2024, a full 100 basis points of cuts in just 9 months. This is helping to buoy stock markets around the world, the S&P 500 is up nearly 1% on Thursday, while the Nasdaq is higher by 1.62%, helping to extend its gains YTD to nearly 15%.
Bulls vs. bears
It is worth noting, that while the Fed remains data dependent, strong data can cause risk sentiment to fall on the back of rising interest rate expectations, while weaker data and lower inflation, can cause risk sentiment to rise and interest rate expectations to fall. The bull case is focussed on disinflation, and a Fed pivot in the second half of this year along with easing bond market volatility. The bear case is more sceptical of the Fed rate cuts that are priced in for the second half of this year due to the persistence of sticky inflation, which continues to surprise on the upside. Core inflation is now above headline inflation, at 5.6% vs. 5% respectively, and shelter costs, airline fares and car insurance are still seeing prices soar monthly, thus it could be too early to pivot. The bear case for stocks is also focussed on recession risks. If the Fed does hike rates in May, and if they keep rates higher for longer to tame core inflation then we could see a nasty, deep recession. This could hurt stocks, which is why bears are on edge and ready to pounce.
Watch earnings season
Earnings season will be a big determinant of whether the bulls will continue to drive the rising stock market and sinking dollar, or if the bears will take charge. Earnings season will begin with aplomb on Friday, with a host of large US banks reporting results. The key things to look out for include: margin compression due to rising inflation, have credit standards tightened due to the recent turmoil with SVB, if yes, where is the tightening taking place – sub-prime loans, corporate, car loans etc, future expectations? There is a low bar this earnings season, with plenty of earnings downgrades for the financial sector, thus a better-than-expected Q1 earnings report could be easy to achieve and boost the bear case as we move through spring.