Pound Could be Set to Capitalise on a U.S. Inflation Undershoot

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Foreign exchange strategists at Morgan Stanley expect this week's U.S. inflation release will undershoot expectations and result in a weaker Dollar.

"We see near-term downside risks to the broad USD from the March CPI print," says Andrew Watrous, Global Macro Strategist at Morgan Stanley.

The U.S. inflation release is the most significant calendar event for global markets this week as it should firm expectations around whether or not the central bank will pull the trigger on an interest rate cut in June.

Morgan Stanley researchers say the CPI fixings market implies a downside surprise 3.36% y/y print, whereas the market is positioned for a reading of 3.5% based on Bloomberg's survey of economists.

Morgan Stanley economists see an undershoot, holding out for a 3.4% outcome.

"The spread between the March CPI fixing and the median economist survey implies a 0.86 standard deviation downside surprise," says Watrous.

Given the historical relationship between CPI surprises and the USD, Morgan Stanley expects a 0.86 standard deviation CPI surprise would be associated with a 0.5% decline in the DXY by 9AM EST (the data comes out at 08:30).

Above: "CPI monthly headline and core inflation to decelerate" - UniCredit.

Such a pullback in the broader Dollar can allow for a Pound to Dollar exchange rate to extend its post-jobs report recovery to 1.27, provided market volatility remains low heading into the result.

FX market volatility is low by historical standards, and this could limit the Pound-Dollar upside in the event of an undershoot in the data. It could also mean that any strength ultimately fades in the hours and days following an initial knee-jerk move higher.

U.S. data has tended to surprised to the upside in 2024 as the economy has proven more resilient than investors expected at the start of the year. This would suggest it will take more than just one soft inflation print to turn the tide against the Dollar.

As 2024 dawned, markets were priced for as many as 150 basis points of Fed rate cuts in 2024, but by the time of writing, this has been whittled down to just 68, boosting U.S. bond yields relative to other markets.

This has, in turn, supported the U.S. Dollar, which is the year's top-performing currency.

The Dollar will remain preferred to other major currencies should this week's inflation figures beat expectations.

Disinflation is stalling and underlying progress remains stubbornly slow. Sticky services and rising gasoline and energy prices all pose upside risks going forward. That said, the lagged impact of falling rents, which make up over half of total inflation, should impact CPI in the months ahead," says Jamie Dutta, Market Analyst at Vantage.

"The 10-year US Treasury yield could make further headway towards the important long-term psychological level at 4.50%, if data is stronger than expected. The dollar will also embark on another upleg and try to make fresh year-to-date highs," he adds.

Bullard Verifies Market Bet Cuts

Above: File image of James Bullard. © Pound Sterling Live. Still courtesy of CNBC.

The market is correct in pricing in approximately three rate cuts for 2024, according to a prominent ex-member of the Federal Reserve's interest rate setting body.

James Bullard said in an interview Tuesday, "at this point, you should probably take the committee and chair at face value — their best guess right now is still three cuts this year."

Speaking in Hong Kong, the former head of the Federal Reserve Bank of St. Louis said that economic data already justifies a rate cut, adding that 75 basis points of easing is "the base case."

"You’re looking at a very successful policy with a pretty strong economy, so a lot of things going right for the Fed right now," he said.

The market expects approximately 70 points of easing, having started 2024 expecting up to 150bp of easing. But the market was well ahead of where the Fed's own conservative projections for the quantum of rate cuts were.

The market has come around to the Fed's opinion and the subsequent paring of rate cut bets has boosted U.S. yields and the U.S. Dollar in 2024.

The question for the Dollar outlook is how much lower these expectations can realistically move, given the significant rerating that has already taken place over recent months.

Should market expectations converge on Bullard's 75 basis point guidance, which is in line with the Fed's FOMC, then we would expect further low volatility FX trade.