Dollar Weakness An "Over-reaction": Commonwealth Bank

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The Dollar's sharp decline against the Euro, Dollar and the majority of the world's currencies was out of step with the nature of the data that caused it in the first place, according to a leading foreign exchange strategist.

Joseph Capurso at Commonwealth Bank says, "USD over-reacted to the small miss in the CPI in our view."

The implications of this over-reaction are that key currency pairs, such as Euro-Dollar and Pound-Dollar are left looking relatively overvalued and prone to a downside correction.

"We expect the 'risk‑on' reaction to the CPI of a weaker USD, lower bond yields and higher equity markets to be unwound," says Capurso.

The Dollar was sold after official figures showed headline CPI inflation in the U.S. rose 3.2% in the year to October, which was less than the 3.3% figure the market was expecting and represented a sharp slowdown on September's 3.7% reading.

CPI inflation was flat on a month-on-month basis, down on September's energy-infused 0.4% advance and below expectations for 0.1%. The outcome boosts a market narrative that the Federal Reserve has done enough to bring inflation back to the 2.0% target.

The Pound to Dollar exchange rate rose 1.80% to peak at 1.25 before market orders around this psychologically significant level triggered a retreat back to 1.2422 at the time of writing. The Euro to Dollar rate hit fresh 2-month highs at 1.0880, but like GBPUSD, was met with market orders that have since resulted in a retreat to 1.0840.

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"The positive reaction from a deceleration in U.S. inflation will give way to worries about the FOMC over‑tightening policy in our view," says Capurso.

Commonwealth Bank's economists expect U.S. inflation to continue to decelerate below the Federal Reserve's 2% target next year.

The market is in agreement, believing the fall in inflation can allow the Fed to cut rates starting from around mid-2024. This expectation has resulted in lower U.S. bond yields, in turn resulting in a weaker Dollar.

But Commonwealth Bank also expects the U.S. labour market to weaken appreciably because of past Fed policy tightening.

In short, the impact of Fed rate hikes is yet to be fully felt by the economy, and as rate hikes continue to work through, economic recession ensues.

"History shows a US recession is a recipe for a higher USD," says Capurso.