After a drop at the start of the week amid hopes of a deal to reopen the Strait of Hormuz, the Dollar(USD) has been trending mostly sideways. Gold has also notably remained at around the same levels. All of this indicates that the markets are in a holding pattern ahead of what could be a major risk event later in the week.
As a hedge against resurgent geopolitical uncertainty, the Dollar(USD) and crude have moved in near tandem since early March. Higher crude prices are expected to raise inflation worldwide. This is a particular issue for the Eurozone, which already had slow economic growth even before the energy disruption. Now, ECB voices are growing in favour of raising rates, which will likely crimp the economy again, weighing on the Euro. The shared currency accounts for 58% of the basket’s weighting that determines the Dollar(USD) index, helping explain the relative surge in the greenback.
What Could Change the EURUSD’s Direction?
Inflation is rising in the US as well, which is raising the odds of a Fed interest rate hike. However, since the news of a potential deal with Iran, those odds have once again receded. Markets now see about 50-50 odds of a rate hike by the end of the year, which is down from 70% at the end of last week. Part of that shift is due to the potential that an end to the war would lower energy prices, making a rate hike unnecessary. Another part is markets getting a better understanding of what the Fed will do under its new leadership.
Inflation will play an important role in the evolution of the currency pair. But both currencies are facing energy cost pressures, so the impact is more balanced. What is likely to be more relevant is economic growth, as that attracts investors to each economy. While investors worry that the Eurozone will slip back into technical recession, the Fed’s GDP Now projects US Q2 GDP will more than double its growth rate to 4.3%. This makes dollars relatively more attractive, and could keep downward pressure on the EURUSD. However, that pressure might be counteracted by other factors.
Fed Changing Its Inflation Focus
One of the important elements to emerge from Fed Chair Keven Warsh’s swearing-in ceremony last Friday was his reiteration that he intended to move away from “backwards-looking” indicators. This echoed comments he made during his confirmation hearing, in which he said the Core PCE was “imperfect” and expressed appreciation for the “trimmed mean” indicator. This would be an important shift for Fed policy and could affect the market’s outlook.
The market has long focused on Core PCE as the Fed’s preferred inflation metric and has hardly tracked the alternative trimmed mean. If Warsh adopts it, it would be a shift closer to central banks like the BOC and away from inflation tracking, similar to the ECB. The trimmed mean is slower than the core rate, thereby reducing the immediate pressure to hike rates in the current environment.
What to Look Out For
The US April core PCE price index, still the preferred Fed measure, is expected to rise to 3.8% from 3.5% previously. The trimmed mean is so infrequently followed that it currently has no estimates, but was recorded in March at 2.4%. The difference gives Warsh some room to address Trump’s demand for lower rates while still remaining data-dependent.
Higher inflation would raise the odds of a rate hike and could support the Dollar(USD), as US economic growth gives more room to absorb the negative impact of higher rates. A miss on inflation, however, could cheer equities and momentarily weaken the dollar.
