We’d said the Euro rally against the dollar was looking stretched, and last week’s market action seemed to confirm our view. The dollar rallied across the board on no particular news, a sign of a trend driven by technical factors rather than fundamentals. The bearish consensus on the dollar as disinflation takes hold in the US means stretched positioning that is vulnerable to a snap back, and that seems to be what happened last week. The greenback rose against every major currency worldwide with the exception of the Colombian peso, which continues to benefit from very high interest rates and is now the top performing currency worldwide so far this year. This week will be packed with critical data releases and policy news. The Federal Reserve meeting on Wednesday is followed by the ECB one on Thursday. Both are universally expected to hike by 25 bp. However, the former is expected to communicate a pause, whereas the latter still has work to do. July PMI indices of business activity in all major economic areas will also be in focus Monday, as will the PCE inflation report out of the US on Friday.
The general sell off in European currencies against the US dollar hit Sterling particularly hard after a surprisingly soft inflation report. This is the first time in many months that has delivered good news on the inflation front for the Bank of England, as both the headline and core numbers came in lower than consensus. It is too early to assume that the disinflation trend visible in the US has also taken root in the UK, but it is certainly a hopeful sign. Markets are still pricing a 50% chance of a jumbo 50 bp hike in August, and UK rates are very likely to end up higher for longer than any other G10 country, which should continue to support the Pound.
The ECB continues to wrestle with the inflation problem. Going by the core index, the disinflationary trend evident in the US has yet to cross the Atlantic. Last week’s slight upward revision to the June inflation number confirmed that the ECB still has work to do. Bringing rates to 4% at its meeting this week is a near certainty. Traders will be paying close attention to the communications from the meeting. In particular, the ECB’s balancing act between weakening growth and stubbornly high inflation should be the key driver of the common currency into the August holidays.
There is perhaps less uncertainty around the Federal Reserve meeting this week than around the ECB’s. The Fed’s meeting on Wednesday is expected to have limited impact on the question whether the short-covering rally in the dollar has further legs. The most likely outcome is a hike, followed by some mildly hawkish rhetoric that will not change the narrative: the excellent news on US inflation means that the Fed can take its foot off the brake and wait a few months for further developments. As long as economic growth worldwide holds up decently, this should allow for a very gradual slide in the dollar against most major peers.