Weak CPI Prompts Larger Than Expected Drop on USD
The deviation from consensus in the US CPI data for October was minimal, with a mere 0.1ppt difference for both the headline and the core. However, it triggered the most significant sell-off of the US dollar since, coincidentally, the October CPI report in November 2022. Back then, the DXY index plummeted by over 2.0% and 1.8% over two days. In contrast, the recent drop amounted to 1.5%. The sell-off a year ago marked a turning point for the US dollar, leading to a further 5.5% decline through the intra-day low recorded in early February 2023. I believe that the dollar's sell-off yesterday could also be significant, indicating another turning point that might extend its weakness.
While there are distinctions between November 2023 and 2022, suggesting we shouldn't expect a similar scale of sell-off this time, a 5-6% further decline of the dollar could bring EUR/USD close to the 1.1500-level. Last year, the November 2022 CPI marked the initial turning point in the surge of inflation, accompanied by global growth optimism driven by China's reopening and a strong rally in China stocks. PMIs in the euro-zone also rose over a three-month period to January 2023, reinforcing positive global growth sentiment. However, the current global growth optimism is not comparable, and I do not anticipate the same scale of dollar selling as seen a year ago.
Nevertheless, the recent move opens the possibility of further dollar weakness. Technically, the backdrop for the dollar is distinctly bearish, as both the 100-day and 200-day moving averages were breached. The last time this occurred on the same trading day was in June 2021, following the peak of EUR/USD after the post-Covid rally.
The fundamental trigger for this movement was the inflation data, which, despite a small 0.1ppt deviation from consensus, suggests potential for continued deceleration. The super core CPI, excluding housing, slowed from 0.61% in September to 0.22% in October, with an annual rate of 3.75%, the weakest since December 2021. Over the last seven months, the super core rate fell to 3.0%, close to the 10-year average of 2.75%. The core CPI rate, excluding housing, dropped to 2.05% annually, while the core goods CPI remained at 0%, the lowest since 2020. Despite these weakening indicators, shelter, the largest component of core CPI, is still at 6.7%, likely to decline based on current rental data.
Consequently, there is a higher likelihood that the Fed has completed its tightening cycle. An 80% probability of a rate cut by May 2024 exists, with 85bps priced by November 2024. If activity data weakens further, additional cuts may be priced, making it very feasible for EUR/USD to advance to the 1.1500-level in 2024.
And UK inflation adds to easing inflation concerns.
The recently released CPI data for October in the UK mirrors the situation in the US from the previous day, with actual readings proving to be 0.1ppt weaker than the market consensus. However, the notable declines in headline inflation from the previous month were more pronounced than in the US, primarily due to the exclusion of the OFGEM utility price increase of 80% in October 2022 from the annual calculation. Consequently, the component related to electricity, gas, and other fuels in housing experienced a substantial shift from a +5.0% YoY to -21.6%. This anticipated change resulted in the headline YoY rate dropping from 6.7% to 4.6%, marking the weakest reading since October 2021. The core rate, although more resilient, still decreased from 6.1% to 5.7%, representing the lowest reading since February 2022.
Despite this, the data breakdown indicates persistently high levels of inflation across most sectors, making it unlikely to instigate expectations of rate cuts, like the situation in the US. The Food, alcohol, and tobacco sector, constituting approximately 15% of the index, continues to register a double-digit YoY rate at 10.3%. Due to substantial month-on-month increases in Q1 this year, this component is expected to decline gradually through to Q2 2024. However, momentum remains decidedly downward following the peak of 16.0% in April. With every other key sector within CPI still running well above 2.0%, except for Transportation (0.50% YoY), the overall inflation scenario remains notable.
Nevertheless, this sharp drop in CPI is likely to reinforce expectations of the conclusion of monetary tightening in the UK. While GBP performance retains some linkage to global risk appetite, the recent substantial decline in global yields and its positive impact on equities have supported GBP, resulting in a marginal decrease in EUR/GBP. Beyond the influence of the US dollar, caution persists regarding the potential for GBP to outperform, given that the impact of monetary policy appears to be exerting more pressure on the real economy, making a mild recession seem likely in the coming quarters.
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