The US CPI report for September turned out to be the turning point for the dollar correction, as we expected. As discussed in our note from the American economist, it was mainly the “super basic” measure of services inflation (excluding housing, ex-energy) that surprised on the upside, reaching a hot 0.6% month-on-month. The increase was mainly due to car and hotel insurance prices, which will decline, but it still complicates the disinflation narrative.
Despite the understandable bearish reaction in bonds and the rally in the dollar, markets for now remain very cautious about pricing in further rate hikes from the Federal Reserve. The implied effective federal funds rate in the futures market for December remains almost unchanged; it was 5.40% on Wednesday and 5.42% this morning. The narrative pushed by Federal Reserve officials that “higher market returns will trigger tightening” appears to be well-founded now.
This new stance from the Fed probably means that for now there will be some reluctance to follow yesterday’s dollar bounce much further (at least if you consider just the rates aspect). Geopolitics seems to have played a rather secondary role in global exchange rate developments despite the ongoing conflict in the Middle East. This morning, the Israeli government warned UN staff to evacuate Gaza and notified Palestinians living in the northern part of the Gaza Strip to head south within the next 24 hours, raising the perceived chances of an imminent great ground offensive. Yesterday, Syrian media reported that Israeli airstrikes hit the airports in Damascus and Aleppo. Meanwhile, the United States has reportedly stepped up diplomatic efforts to prevent the conflict from spreading to other fronts in the Middle East.
Clearly the situation remains too volatile to make a prediction on the impact on the market, but it is fair to assume that the start of an Israeli ground offensive in Gaza may encourage more defensive trading and favor currencies such as the dollar, Swiss franc and the yen, as some investors assess a greater risk that the conflict will spread to other fronts. The impact on the commodities market has been contained so far, but further upward pressure on oil prices may also benefit the dollar.
There are also potential risk-aversion implications from the prolonged impasse in the US House speaker race, as Rep. Steve Scalise abandoned his campaign to become the new speaker after just a few days. This could have implications not only for domestic fiscal financing but also for military aid to Israel and Ukraine, which President Biden has promised to deliver but will now face hurdles to approval.
We suspect that political and geopolitical events will begin to take center stage in the forex market over the weekend. The US calendar includes today’s University of Michigan surveys and the focus will be, as always, on inflation expectations indicators, which are expected to have remained stable. Patrick Harker is the only scheduled Fed speaker.