Dollar's Strength: A Consequence of Limited Alternatives

FX Daily: Dollar benefits from a lack of alternatives

The US remains on an encouraging disinflation track, but the dollar is not turning lower. This is, in our view, due to a lack of attractive alternatives given warning growth signals in other parts of the world (such as the eurozone and China). Evidence of a US economic slowdown is needed to bring USD substantially lower.

 

USD: Disinflation not enough for the bears

July’s US inflation numbers released yesterday were largely in line with expectations, reassuring markets that there are no setbacks in the disinflationary process for now. Core inflation inched lower from 4.8% to 4.7%, while the headline rate suffered a rebound (from 3.0% to 3.2%) due to a reduced base effect compared to previous months, which was still smaller than the consensus of 3.3%. With the exception of resilience in housing prices, price pressures clearly abated across all components.

All in all, the US report offered reasons for the Fed and for risk assets to cheer, as the chance of another rate hike declined further. Equities rallied and the US yield curve re-steepened: the dollar should have dropped across the board in this scenario. However, the post-CPI picture in FX was actually more mixed. This was a testament to how currencies are not uniquely driven by US news at the moment. The Japanese yen drop was not a surprise, given abating bond and FX volatility, equity outperformance and carry-trade revamp, but FX markets seemed lightly impacted by CPI figures and the subsequent risk-on environment, as many high-beta currencies failed to hang on to gains.

From a dollar point of view, we think the recent price action denotes a reluctance to rotate away from the greenback given the emergence of concerning stories in other parts of the world. This is not to say that the activity outlook in the US is particularly bright – jobless claims touched a one-month high yesterday, and the outlook remains very vulnerable to deteriorated credit dynamics – but if economic slowdown alarms are flashing yellow in Washington, they are flashing amber in Frankfurt and Beijing. Chinese real estate developer Garden reported a record net loss of up to $7.6bn during the first half of the year yesterday, at a time when China’s officials are trying to calm investors’ nerves about another potential property crisis.

Back to the US, PPI and the University of Michigan inflation expectation figures out today will clarify how far the disinflation story has gone in July, but we still sense a substantial dollar decline is not on the cards for the moment, or at least until compelling evidence of slowing US activity makes the prospect of Fed cuts less remote. DXY may consolidate above 102.00 over the next few days.