U.S. Dollar and Markets Eye Key U.S. Inflation Report with Trepidation

- Critical inflation release due midweek
- Comes as USD demand wanes
- Stock markets slump on elevated inflation fears
- Bumper inflation data could accentuate moves

Image © Adobe Images

• GBP/USD spot rate at time of writing: 1.4123
• Bank transfer rate (indicative guide): 1.3728-1.3827
• FX specialist providers (indicative guide): 1.3930-1.4023
• More information on FX specialist rates, here
• Set an exchange rate alert, here

The stars are aligning for Wednesday's U.S. inflation data release to be the most consequential for the Dollar and global markets in years.

Ahead of the release of the inflation figures global markets are suffering a sizeable wave of selling as investors fret about the prospect of higher inflation rates, driven by global supply constraints and rising wages in the U.S.

The fear is that rising inflation will force central banks to withdraw their generous supply of liquidity into the global economy, which has fuelled a boom in stock valuations and driven 'high beta' currencies higher.

"Tech stocks dragged US markets lower at the close, while major Asian indices are also lower overnight, including Japan’s Nikkei (down more than 3%). Concerns about rising inflation has been cited as a factor weighing on risk sentiment ahead of US CPI figures tomorrow and with further inflationary pressures in the pipeline as a result of the recent surge in some commodity prices," says Hann-Ju Ho, an economist at Lloyds Bank.

Foreign exchange markets are meanwhile relatively unscathed by the equity markets action, although analysts say the inflation story will almost certainly have a bearing on these markets going forward.

"A stronger than expected CPI reading tomorrow could provide some much needed support for the US dollar although the hurdle is much higher now following the softer non-farm payrolls report," says Lee Hardman at MUFG.

Above: The GBP/USD has firmed ahead of the key inflation report. A strong set of figures stunt the gains

Ahead of the report the Dollar has come under pressure, largely owing to the soft jobs data released in the U.S. the preceding Friday.

The U.S. disappointed by adding far fewer jobs than the market was expecting, leading investors to bet that the Federal Reserve (Fed) would be content to sit on its hands and keep quantitative easing generous and interest rates low.

Standard central banking theory suggests that a central bank raises interest rates and exits quantitative easing when inflation is running hot, as this reduces the flow of money through the economy and cools activity.

Higher interest rates in turn tend to be supportive of the currency that central bank issues.

But the Fed has said it will only concentrate on controlling inflation when the U.S. labour market is back on its feet, suggesting a string of bumper jobs reports were required before they shifted their stance on policy.

The bet going into this week's inflation report had been the Fed will look through searingly-hot wage rises as long as the jobs market is struggling.

{wbamp-hide start}

This is bet is now being questioned by nervous investors.

Indeed, it is almost ironic that the inability of the U.S. to meet expectations for jobs creation could be the source of the most toxic input to inflationary pressures.

"Market participants will be scrutinising the report closely for any signs that the pick-up in inflation is more than transitory," says Hardman.

"It has already been suggested that the softer than expected payrolls for April could be due to labour supply constraints more than a lack of demand which would create a more inflationary outcome if it proves persistent," he adds.

The consensus is looking for CPI inflation to have risen 3.6% in April.

A beat on this estimate could well exacerbate equity market sales and rejuvenate support for the Dollar.

Secure a retail exchange rate that is between 3-5% stronger than offered by leading banks, learn more.

Foreign exchange analysts note that the Dollar has shown increased sensitivity to inflation reports in 2021.

"The dollar index has weakened in the first 30 minutes following the last three CPI reports," says Hardman.

Foreign exchange analysts at Barclays tell clients in a weekly currency briefing that markets are likely to remain in data-driven mode, and this week’s focus will be on the CPI report.

They forecast headline CPI to have increased 0.05% m/m in April (+3.4% y/y) and expect core CPI to rise 0.20% m/m (+2.2% y/y), driven by firmness in goods inflation amid moderate price pressures in the services sector.

"The USD’s reaction to inflation surprises has increased over the past year, and a strong print this week could remove some of the downward pressures on the dollar," says the Barclays report.

Inflation expectations have risen sharply in 2021 - not just in the U.S. but globally - driven in part by tight supply constraints that have their roots in the Covid-19 crisis.

For example, the supply of chips is a significant concern for the global manufacturing chain and vehicle output has been particularly hard hit.

The surge in the price of commodities is another driver of price increases, not just via rising oil prices but also via rising copper and iron ore prices.

Huge fiscal stimulus aimed at jump-starting economies from their Covid-induced setbacks are fuelling demand for those components that infrastructure booms are built on, particularly in China.

"Copper and iron ore have both set new record highs in the past week, but we think there is still further upside to their prices. Supply tightness aside, the run-up in metal prices has and is still being driven by robust demand both from China and the global Green Revolution," says Howie Lee, Economist at OCBC Bank in Singapore.

While much of the inflation concerns have been built on supply constraints (temporary issues) signs that demand pressures caused by wage hikes and labour shortages (less transitory) will be of greater consequence for markets.

Wednesday's data should therefore shine some light on the structure of the inflation markets are facing.