Milder US CPI After PPI Miss?
US two-year yields dipped below 4%, and the dollar weakened for the third consecutive session yesterday after US producer prices came in below expectations (2.4% vs. 2.6% y/y), driven by a significant drop in services. While the correlation between producer and consumer prices isn’t strong, PPI influences CPI, suggesting a potentially softer US CPI print today.
Benign inflation data would be well-received by investors, validating expectations for multiple Federal Reserve (Fed) interest rate cuts this year. Currently, markets are pricing in over 100 basis points of easing before year-end, equivalent to four quarter-point cuts. The Fed funds rate is projected to reach a “neutral” level of 3-3.25% by mid-2025. However, the path for Fed policy rates remains highly uncertain due to the US central bank’s data-dependent stance. The data is mixed; despite headline PPI figures indicating ongoing disinflation, underlying data shows 80% of sub-components are increasing annually. Meanwhile, the NFIB’s Small Business Optimism index rose to its highest level since February 2022, yet sentiment remains significantly below the 50-year average, and the uncertainty index hit its highest since November 2020.
What does this mean for the US dollar? Generally, softer inflation supports the idea of Fed easing, reducing the dollar’s yield advantage. Thus, a brief period of dollar weakness could occur if the data allows. Weak activity data also undermines the dollar’s high growth advantage, but if too weak, its safe-haven appeal activates. Therefore, we cannot yet dismiss the strong dollar regime, especially with structural factors like tariff risks and increased US fiscal stimulus ahead of the election still supporting it.
Pound Drops on Soft CPI Print
The highly anticipated UK inflation report was released this morning, showing the headline rate rising to 2.2% YoY, the first increase in 2024, but below market consensus and BoE forecasts. The core print was 3.3%, and services inflation, closely watched by the BoE, was 5.2%. The probability of a September rate cut remains below 50%, and the pound has dropped 0.2% since the print was released.
The pound, a star performer in the FX space this year, has been under pressure over the past month due to wavering global risk appetite and bets on BoE rate cuts, denting its appeal. However, yesterday’s unexpected drop in UK unemployment and the fall in wage growth attributed to base effects suggest the BoE will move slowly on rate cuts. Hence, GBP/USD reclaimed $1.28, closing above its 50-day moving average and re-testing its 200-week moving average, a critical trading point this year. GBP/EUR also rose above its 200-day moving average, recapturing the €1.17 handle after slumping to a four-month low near €1.16 last week.
Today’s figures contribute to a mixed set of UK economic data that investors are monitoring for signs of when the BoE might lower borrowing costs again. Traders are betting on at least one more cut this year, but lower price pressures could pave the way for more reductions. Additionally, the normalization of the breadth of services components rising versus falling continues. If this trend persists in August and the BoE’s assumption of sticky services CPI diminishes, a September cut cannot be ruled out.
Euro Shrugs Off ZEW Miss
Germany’s ZEW Economic Sentiment report for August fell to its lowest level since January, continuing a trend of disappointing domestic data and recent global stock market turmoil. The expectations gauge dropped sharply to 19.2 from 41.8 in July, significantly below the market consensus of 34. An index of current conditions also declined more than expected. Economic expectations are likely influenced by high levels of uncertainty, driven by ambiguous monetary policy, disappointing US business data, and growing concerns over escalating Middle East conflict.
Germany faces minimal economic expansion this year, weighing down Eurozone economic momentum. Despite this, markets have shrugged off the stark warning. ECB rate-cut wagers remain steady, indicating a 25 basis point easing in September and 70 basis points by year-end. Investors continue to focus almost exclusively on US-centric developments. Indeed, the euro climbed towards $1.10, nearing January levels, after soft US wholesale inflation data bolstered confidence that the Federal Reserve may soon cut interest rates.
Markets are stabilizing, but implied volatility indicates lingering uneasiness ahead of the US CPI release. Overnight EUR/USD implied volatility surged to 9.6%, nearly twice the year-to-date average. After the weak NFP report, markets have become more jittery around data releases.
