The U.S. dollar traded lower against all of the major currencies after the U.S. inflation report showed consumer prices slowing in the month of July. Overall inflation grew by only 0.5%, down from 0.9% the previous month, but core price growth was weaker than anticipated. In yesterday’s note, we highlighted the recent decline in lumber and used car prices as reasons why traders should expect inflationary pressures to ease. Even though the slowdown was anticipated, investors had a strong reaction to the report. U.S. stocks hit record highs, Treasury yields declined and currencies, like the euro and the New Zealand dollar shot higher against the greenback.
What’s interesting about today’s reaction is that inflation is not really cooling. Prices continued to rise from the previous month and, on a year-over-year basis, CPI growth remained unchanged at 5.4% (it was expected to slow to 5.3%). So while Federal Reserve officials may be relieved that price pressures did not accelerate more rapidly, the continued increase in CPI keeps the central bank on track to announce taper in the next six weeks. With stocks trading at record highs, the central bank can afford to signal a change sooner. Fed presidents are divided on timing, but most agree that monetary policy changes are needed in the near future. Fed President Esther George thinks the time has come, but Fed President Robert Kaplan thinks they can wait until September to telegraph a change for October.
For all of these reasons, the U.S. dollar’s decline today can best be described as modest, which is consistent with the less than 1.5% drop in 10-year rates. The New Zealand and Australian dollars benefitted the most from U.S. dollar weakness and the risk-on rally. The resilience of AUD is surprising with the government extending lockdowns in Sydney and Melbourne after the number of new COVID-19 cases in Sydney hit new record highs. Originally set to end Aug. 28, restrictions will remain in place through September. Melbourne will remain in lockdown until Aug. 19, but that date is likely to be extended as well. It is no surprise that consumer confidence has fallen in lockstep with business confidence. The only explanation for the rally in AUD aside from U.S. dollar weakness is the prospect of a strong recovery. The Reserve Bank expressed its confidence in the snapback earlier this month and, given the trajectory of other economies, there are strong cases supporting its positive outlook.
Sterling will be in focus tomorrow with second quarter GDP numbers scheduled for release. Considering the prospect of very strong data, GBP has been trading unusually quietly. Restrictions were eased as vaccination rates shot up in the second quarter. Tomorrow’s report is expected to show a sharp recovery that should invigorate discussions about fewer asset purchases from the Bank of England and lift GBP/USD in the process.