The Fed’s policy pivot will attract more attention in the week ahead as the other main driver of USD performance. The week ahead is expected to be pivotal for USD performance through the rest of this year with the release of the latest US CPI (Tues) and final FOMC meeting of this year (Wed). US CPI report releases have triggered larger market reactions in recent months as speculation intensifies over a turning point for inflation and shift in the Fed’s policy stance. The 0.2ppt downside surprise for the M/M core CPI reading in October resulted in the dollar index falling sharply by an outsized -2.1% in the first six hours after the report was released, and the sell-off has continued to date as it has now fallen by around -5.5%. Ahead of the next US CPI release in the week ahead, market participants are anticipating further confirmation that underlying inflation pressures (+0.3%M/M expected in November) are beginning to ease from an elevated starting point, which if confirmed should keep the USD on a softer footing heading into year-end. On this occasion though, an upside inflation surprise poses a greater risk of a bigger market reaction after the sharp weakening of the USD over the past month. The US CPI report has the potential to overshadow the impact from the latest FOMC meeting. The Fed has been clear that it plans to deliver a smaller 50bp hike next week. USD performance will be driven mainly by: i) whether Chair Powell signals clearly that another step down in the pace of hikes is likely at the next FOMC meeting posing downside risks for the USD, and/or ii) whether the Fed signals that the policy rate will need to be raised to a higher peak above 5.0% in 2023 and remain higher for longer in 2024 posing upside risks for the USD.
While we are confident that the USD has now peaked alongside US inflation, and expect both to weaken further in year ahead, there is a material risk that the upcoming US CPI and FOMC meetings could trigger a USD short squeeze heading into year-end. A stronger core inflation reading would be the most disruptive outcome for markets.
- MUFG
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