The major risk event for the week is Wednesday’s US CPI release. This could shift market views on the dollar outlook and move major currency pairs in response. The consensus is for inflation to accelerate. This could initially support the greenback, as it would imply a more hawkish Fed. But traders are still cautious about changes the new Fed Chair will make. In addition, they are watching how those changes affect the data’s implications for the future of monetary policy.
Last Friday, US NFP came in much hotter than anticipated, with the prior two months’ readings revised higher. Not only that, but March NFP was revised over 200K, the first time in more than a year. The subsequent months were just below 180K, which is crucial because that’s around the replacement level. The number of open jobs increased in April as well. All of this strongly suggests that the US labour market is not just in recovery mode but has actually recovered.
Making the Case for a Hike
The strong labour data undermines the arguments of doves on the FOMC who have been calling for easing. With inflation well above target, the only reason not to tighten was to support the labour market. On the other hand, if job numbers are back to growth and have been for a couple of months now, it means that the Fed needs to focus on inflation.
The new Fed Chair, Keven Warsh, has notably put emphasis on combating inflation, even after being appointed by US President Donald Trump. Trump has pushed for lower rates. Just as recently as Sunday, Trump urged the Fed to cut rates. So, traders are looking for ways for Warsh to appease the White House while also preventing inflation from rising. That makes the rate trajectory a little uncertain.
Why the Odds of a Hike Are Low
Despite recent data, futures are not fully pricing in a rate hike by the end of the year. The odds sit at just 70%. This means there is still upside if the upcoming CPI data comes in hotter than expected. But it also means markets are just as likely to lower the odds if the data is cooler. That’s to say, upcoming data could substantially shift markets if it doesn’t meet expectations.
The consensus is that the US May headline CPI will rise to 4.0% from 3.8% a month earlier. This would exceed the Fed’s target. The gains are attributed almost exclusively to higher energy prices. The core rate, which the Fed has more closely followed up until now, is projected to tick up to 2.9% from 2.8%.
Gauging the Market Reaction
A beat of expectations would likely raise the odds of a Fed hike by the end of the year and support the dollar. Even the alternative measures that Warsh might consider to tamp down inflation without hiking would likely support the dollar. Warsh has cited former Fed Chair Alan Greenspan, who famously kept rates low, but managed inflation expectations through the balance sheet. By adjusting the timing of its Treasury holdings, the Fed could allow short-term rates to rise and control inflation. That would thereby support the dollar. Meanwhile, the Fed could put downward pressure on the 10-year Treasury yield to satisfy the White House.
If inflation is cooler than expected, it would likely reduce the chances of a Fed rate hike. However, it would also support the stock market, which could in turn support the dollar in the medium term. Meaning that dollar weakness after CPI, if it happens, will likely fade quickly. That is, unless there is a surprise development in the war in the Middle East that overshadows the data.
