FX Daily: Dollar bears may have jumped the gun

The dollar plummeted yesterday after a softer-than-expected US CPI reading. But we still think a turn in activity data - more than the disinflation story - is needed to take the dollar sustainably lower, and the move appears overdone also from a short-term valuation perspective. US retail sales will tell us whether the dollar can start to recover today.

USD: Dollar slump looks overdone

We had pointed to the risk of a USD correction yesterday given the chances of a soft CPI reading, and the tendency of the dollar to underperform after key US data releases/events. The move was, however, quite extreme. If position-squaring did play a role in exacerbating the size of the dollar correction, the depth of the drop in Treasury yields means the FX shifts have taken their cues from a substantial repricing of monetary policy expectations.

The Fed funds futures curve erased any residual bet of monetary tightening after the lower-than-expected October inflation report, and now prices in the start of the easing cycle in June and 50bp of cuts by July. We have no reason to argue against this pricing from a macro perspective: our US economist discusses here how disinflation has much further to go, and we currently forecast 150bp of Fed cuts in 2024, still more dovish than the 97bp priced in by the market. However, we’d be wary of jumping too aggressively on a dollar bear trend now.

First of all, markets have moved a lot after a softer inflation reading, even though the narrative of disinflation being well underway is something that would hardly surprise the Fed. The month-on-month core print, by the way, came in at 0.227%, not too far from a rounded consensus 0.3%. Resilient growth is what's been keeping the dollar stronger, and while we expect the US to head into recession in 2024, there is no hard evidence just yet. In other words, strong US activity figures remain a very clear possibility in the near term and could trigger an inversion in the US bear run.

Secondly, rates have moved significantly, but not enough to justify the huge dollar drop. According to our short-term fair value model, the dollar has moved into undervaluation (after the US CPI release) against all G10 currencies except for the Japanese yen, Canadian dollar and Norwegian krone. This is quite remarkable given the dollar had been generally overvalued in the short term for many months.

Today, October retail sales will be watched closely after coming in very strong in September. Consensus is for a 0.3% MoM decline in the headline figure but a 0.2% increase in the index excluding auto and gas. The dollar should be very sensitive to the release. A soft reading may fuel speculation that softer growth is coming through and could add to disinflation to trigger more Fed dovish bets. However, US activity data has had a tendency to surprise on the upside, if anything, and it may be too early to see a slew of soft readings. Our view is that this USD bear run is overdone, and we expect another, or a few more rounds of dollar resilience into the New Year before a clear-cut dollar decline can emerge.

PPI data will also be watched for confirmation that the disinflation process effectively accelerated in October. On the geopolitical side, keep an eye on headlines from the Biden-Xi Jinping meeting at the APEC summit.