Wednesday’s release of US inflation data is likely to be the pivotal point for the dollar and gold this week. Market sentiment shifted noticeably after last week’s US jobs report was a major surprise. Now, traders are looking for confirmation of the new direction, which could set the course for the next Fed meeting.
July Non-Farm Payrolls came in well below expectations and turned negative at -23K. The real blow came from the downward revisions to prior months, showing the US generated 103K fewer jobs in May and June than were initially reported. This left the jobs market in steady decline for the last five months, a warning sign for the Fed.
Bad Data is Building
The downward revisions are significant in the context of the surprisingly soft Q2 GDP data. Traders that might have been hoping the growth figure would be revised higher to support the dollar have an indication they might be disappointed. With the US economy slowing down and the jobs market showing definite weakness, the dollar could come under pressure.
That’s before taking into consideration what the Fed is likely to do. Up until now, Chair Kevin Warsh has been adamant about bringing down inflation, which has left the market betting the Fed will focus on price stability over the jobs market. However, rising slack in the jobs market means the Fed will have to consider its second mandate of ensuring full employment.
The Shifting Fed Outlook
To complicate matters, the unemployment rate remains steady due to a drop in the labour force participation rate. The JOLTS report earlier in the week continued to show a low-firing, low-hiring dynamic in the market. This generalised slack is likely leading more Americans to give up on finding a job, which is a drag on inflation. If wages are not rising, demand will fall, and prices will likely stabilise as consumer sentiment is undermined.
Following the data release, the outlook for the September FOMC meeting flipped. Prior, markets saw the odds of a hike at 60-40. Afterwards, the odds flipped to 60-40 for a hold. While significant, it indicates that the market isn’t fully pricing in a shift in Fed outlook. It’s likely waiting for the inflation data to either confirm the shift or go back to expecting tightening.
What the Market is Looking for
The consensus is for US July CPI to come in at 3.4% on the headline, slightly down from the 3.5% prior. This is despite expectations of a modest increase in fuel prices during the month as the Strait of Hormuz closed again. The core rate is projected to decline modestly as well, to 2.5% from 2.6% prior.
While this is going in the right direction, it still leaves inflation well above the Fed’s target, justifying at least one rate hike, assuming no further deterioration in the jobs market. The case would get even stronger if inflation surprised to the upside and actually increased. However, the potential upside for the dollar might be limited as traders become increasingly concerned about the economy. On the other hand, a miss would dovetail with the latest jobs data and could substantially reduce the odds of a rate hike in the near future. This could end up weakening the dollar, but supporting gold.
