Post date: 02/09/2020 09:35
Last week capped an unusually busy month of August in financial markets. A combination of massive easing from the central banks around the world and guarded optimism about a COVID vaccine has brought the biggest August rally in US stocks in decades, but has been unambiguously negative for safe-havens and, more meaningfully, the US dollar. The Federal Reserve did the greenback no favours, announcing a significant dovish shift in its future policy, promising that it will now tolerate periods of above-target inflation in order to compensate for the time that inflation remains below the 2% target.
The selloff in the US dollar has been particularly strong against currencies with significant commodity exposures, as the sector is expected to benefit from the Fed’s increased tolerance of inflationary pressures. The one exception has been the Brazilian real, which continues to be pressured by fiscal concerns and the country’s poor response to the pandemic. Traders returning from holidays will have a full plate of macroeconomic news this week. Eurozone PMIs of business activity and inflation for the month of August released Tuesday through Thursday will set the stage for the critical August employment report out of the US on Friday.
Sterling has been one of the main beneficiaries of the risk-on mood in markets this summer, and has outperformed all non-commodity G10 currencies to rise to a two-year high against the US dollar. In doing so, it looked past the lack of any visible progress in the Brexit negotiations and some mixed economic data.
This week is unlikely to bring fresh news on either the pandemic or the Brexit negotiations. Given that speculators seem to be very short the US dollar, and the very sharp rally of Sterling over the past few weeks, there is a good chance of temporary pull backs on any disappointment over economic news or Brexit negotiations.
The scorching rally in the euro against the dollar received a fresh impulse from the Federal Reserve’s announcement of a “flexible targeting” policy that will be more tolerant of above-target inflation in the future. While we remain positive on the common currency in the long-term, the speed of the recent move, the stretched short dollar positioning of currency speculators and the mixed nature of recent economic and pandemic news out of the Eurozone may make it vulnerable to short-term pullbacks. Meanwhile, this morning’s August inflation report delivered a massive downside surprise. Headline consumer price growth fell into negative territory year-on-year – the first time it has done that since 2016. The immediate reaction in the currency markets was to send the common currency lower, although the move thus far has been limited, to say the least.
The momentous change in inflation management announced last week by the Federal Reserve increases our confidence in our long-term bearish view of the US dollar. The Fed stated that it will tolerate inflationary outcomes above its target of 2% so as to maintain the average around the target. What this means for the medium-term is that the barrier for any future interest rate hikes is even higher than the market anticipated. Higher inflation will no longer on its own be sufficient to warrant them. Financial markets have reacted as one would expect, sending the prices of commodities and stocks higher while long term bonds and the US dollar sell-off. For the short-term, we think resistance to further sell-offs in the dollar is building up as speculators become ever more stretched in their consensus dollar bearish positioning. A positive job market report on Friday may provide a catalyst for a short-term short covering rally in the dollar.