FX Update: US Dollar volatility to continue

The USD has been rangebound lately, even with a hawkish Fed. Markets are interpreting any “softer” data in favor of a Fed pivot, sending EURUSD up. However, a high CPI print tomorrow may send EURUSD down while the dust around US election settles.

In the last month, EURUSD has trended higher trading in the range 0.97-1.01 as investors have shifted their focus towards the end of the Fed’s aggressive hiking cycle. Sentiment has also lifted EURUSD with the prospect of a divided US Congress while the expected Republican Red sweep seems not to have materialized, and a rumored Chinese reopening brightening the gloomy global growth outlook.

Chart 1: EURUSD has been rangebound lately

Admittedly, the latest upward swing EURUSD is in contrast to our view for a stronger USD ahead, but we think recent price action is a reflection of tactical positioning rather than a change of fundamentals. If anything, the reopening of China – when it eventually comes – will complicate the inflation picture by putting new upwards pressure on commodity prices, in particular energy. Moreover, who is in charge of Congress is a topic that will wane. The topic that will not wane any time soon is the Fed’s fight against inflation. The Fed has said clearly that a pause of its rate hikes is off the table so long as inflation is high. The fight against inflation means higher rates and more pain for risk assets and the real economy. It seems that stock markets investors refuse to get the memo and are interpreting any “softer” data in favor of a Fed pivot, leading to risk on and a weaker USD. Eventually the tide should turn and investors will again feel the pain and remember the old adage: “don’t fight the Fed.”

Looking ahead, EURUSD will likely continue to have a bumpy ride but we still hold our view for a lower EURUSD towards the end of this year (around 0.95). What we are seeing now is that investors are becoming more divided when interpretating economic data and implications for monetary policy. Confirmation bias surrounding the incoming data makes some certain of a Fed pivot even if the data shows otherwise. Several central banks slowing the pace of hikes has led to a belief that rate cuts are not far away either. Some are emphasizing the risks of overtightening, however, the Fed sees a risk of not tightening enough or pausing too early to bring inflation under control.

Ahead of the December FOMC, the decisive data will be the two inflation reports and two job-market reports. Looking at the latest US economic data we see little suggesting that a pause of rate hikes is in sight. On the contrary – as Chair Powell alluded to – strong economic data warrants more tightening ahead than expected at the September FOMC meeting. We have already had the first Nonfarm Payrolls report out last Friday, which was stronger than expected with a creation of some 575.000 new jobs over the last two months. Labour market participation fell slightly to 62.2%, below 63.4% before the pandemic. More worrying, monthly wage growth accelerated to 0.4% from 0.3%. All of this points to a tighter labour market and wage growth that is way too high for inflation to come back to 2%. Some have focused on the fact that the US unemployment rate rose to 3.7% from 3.5% and year-over-year wage growth fell to 4.7% from 5%. The Fed will likely trust the nonfarm payroll ‘establishment’ data compared to the unemployment data which is a result of a household survey. Moreover, year-over-year wage growth is no longer the thing to look at due to base effects kicking in. In sum, if you think the US labour market and wage growth are softening, then look over the data again.

Chart 2: US labour market remains tight

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Tomorrow’s CPI inflation report is the next key figure in the short-term. The rise in CPI will likely slow on a year-over-year basis, but the Fed has shifted their focus to the monthly readings because of base effects. And that is where markets risk being disappointed again. We expect the October Core CPI to rise by 0.5% from the prior month – pointing to inflation well above the Fed’s mandate – with housing and service categories pulling up inflation, while supply-side categories, like used cars, and health insurance prices should become a drag. Higher-than-expected inflation figures have been a trigger for a stronger USD (6 out of the last 10 CPI releases this year – see Chart 3) and that could easily be the case this week as well, especially when the data shows that financial actors are net short USD – see chart 4.

Chart 3: EURUSD has fallen 6 out of the last 10 times after the release of the CPI data

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Chart 4: Positioning data shows non-comercial players are net short USD

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