A global nightmare called Inflation

Global financial markets breathed a sigh of relief, as the chairman of the Federal Reserve System (FRS) Jerome Powell said yesterday in his speech to Congress that he can cope with the difficult task of fighting inflation without damaging the economy. 

He calmed the nerves of investors, saying that the Fed "is just going to move to a policy that is closer to normal during this year, but it's a long way." Let's hope that throwing easy money to keep financial markets on track for a record year was the easy part of the task, now it's time to pay the bill and the bill is high as the party was insane. 

All attention is focused on US inflation, as data show that US consumer prices have risen above the 7% mark, the highest in four decades, but investors believe that inflation will peak this month and the trend will change. But the truth is, no one knows where we're going, all we know is that the Fed has waited too long before taking action, and if today's inflation turns out to be higher than expected, the recent stock gains will melt like snow in the sun. 

Jerome and the Three Bears 

Federal Reserve Chairman Jerome Powell, testifying at his confirmation hearing on the Hill, soothed markets overnight in a performance worthy of Goldilocks and the Three Bears. Mr Powell noted that the Fed could hike rates to rein in inflation, intended to start the balance sheet run-off sooner rather than later, but also said inflationary pressures would peak mid-year. What he didn’t say was also important. He didn’t back four rate hikes in 2022, nor a March start to hikes, nor did he give any details on when the Fed balance sheet run-off would start. 

It was a masterful performance really, leaving the bowls neither too full nor too shallow; but just right from the financial market’s perspective. Ignoring recent comments from hawkish FOMC members while reinforcing that the Fed has likely accomplished its employment objective and was well aware of the inflation one. Certainly, if Mr Powell believes inflation will peak in H2 2022, there seems no need for a panicked start to hikes in March, let alone four of them. If anything, that the Fed has shown over the past two years, it is an abundance of caution and patience. 

This was enough to unleash the dwarf buyers who had strained the leash in the last few sessions. Stocks rose, oil rose, U.S. yields fell, the U.S. dollar fell, and even gold rose. Even if the Fed raises the rate to 1.0-1.25% this year, the real US yield will still be very negative. 

What is Going on with the Dollar? 

Inflation is a hot topic and will likely dominate the agenda for most of the year. Yet despite rising to 7.0%, the highest print since the 80s, the CPI measure of inflation failed to have the sort of impact you would expect from the dollar. The greenback fell across the board on Wednesday, before extending its declines in the first half of today’s session, as the PPI measure of inflation also had not impact. 

Coming hot on the heels of that 7% rise in consumer inflation, today we found out that producer prices also remained very high. The PPI measure of inflation was stronger-than-expected on the core front (8.3% y/y vs. 8.0% eyed), but slightly weaker on the headline front (9.7% y/y vs. 9.8% expected). The slight weakness on the headline PPI number was due to the 6% drop in the index for gasoline. However, with WTI climbing above $82, this component of the PPI is likely to have risen back. 

So, price pressures show no signs of abating, and with the Fed turning even more hawkish, why isn’t the dollar rising? 

While there are a few good reasons behind the dollar’s performance, as I will discuss below, the greenback is unlikely to remain in protracted bear trend for too long. I reckon it could recover sooner rather than later. 

Foreign investors are likely to be reducing their equity holdings in the US, possibly favouring Europe, where the markets are likely to remain supported on the back of the ECB’s ongoing support and the potential for a strong economic recovery. Buying stocks in Europe means there is demand for euros, pounds and francs etc. 

Additionally, there is a real risk that high levels of inflation could hurt consumer demand, which could weigh on economic activity, especially with omicron spreading like wildfires. This is tun may mean the Fed will slow down or pause its hiking later this year. 

Still, the above consideration may only have limited impact on the dollar. I wouldn’t bet against the greenback making a comeback, especially with many major currency pairs having reached key technical levels, with the EUR/USD being a spitting distance away from the 1.15 handle.