Sticky Inflation Keeps Dollar Higher for Longer

Overview

The dollar remains broadly bid after Friday's release of US PCE inflation data argued that the Fed needed to push rates higher and for longer. 25bp Fed hikes are now priced for March, May and June. Expect the dollar to hold gains this week, although China's February PMIs (Wednesday) and the US ISM Services (Friday) may prove a challenge…

USD: Hard to argue with dollar strength near term

The release of US core PCE inflation data for January on Friday concluded a month of US data that has been favourable for the dollar and unfavourable for bonds. The data showed that US inflation is more persistent, and US economic activity is stronger than anticipated in December and January. Consequently, investors are now taking the Federal Reserve hawks seriously and have already priced in three more 25bp rate hikes from the Fed in March, May, and June.

The hawkish data raises questions about the new set of Fed Dot Plots, which will be released on March 22. The Fed's current median expectation is for Fed Funds to be at 5.00-5.25% by the end of 2023 and 4.00-4.25% by end-24, both of which could be revised higher. This possibility may deter investors from entering dollar short positions in the next few weeks. The US 2–10-year yield curve is also the most inverted since the mid-1980s, which poses a challenge for risk assets. It is unlikely that global equity markets will continue to rise until central banks show clear signs of easing their tightening cycles.

This week, the ISM business confidence data in the US, particularly the release of ISM services on Friday, will be the macro highlights. If the January services release's rebound was due to better optimism, it could set the trend for US data in March. Additionally, investors will be closely monitoring the Chinese February PMIs released on Wednesday. A strong showing could support the renminbi and activity currencies in general, although geopolitics may weigh on the renminbi.

As for the dollar, the DXY broke above 105.00 on Friday, and the multi-week bias suggests resistance at the 106.20/106.50 area, about 1.00/1.20% above current levels. In March, it will be clearer whether these levels will be the best for the dollar this year.

EUR: Dollar strength to keep EUR/USD heavy

Similar to the Fed, the European Central Bank is also adopting a hawkish stance. Investors are fully onboard with the ECB's plans to raise rates by 50 basis points on March 16th and are pricing in an additional 80 basis points of tightening by year-end. This approach contrasts with the Fed's likely trajectory, which could include a rate cut by year-end. It seems probable that the ECB will maintain its peak rates throughout most of 2024.

Although there isn't much Eurozone data this week, the region's business and consumer confidence figures for February are expected to show modest improvement. However, for EUR/USD, the strong dollar is likely to be the dominant factor. It is anticipated that 1.0500 will be tested, and there is a possibility that could briefly drop to the 1.0460 area.

GBP: Northern Ireland trade deal yet to provide a sterling boost

Thus far, sterling appears to be paying little attention to the potential improvement of trading and political relations between the UK and the EU. It is expected that an agreement will be announced later today to ease trade barriers on the Irish Sea. It remains to be seen whether this development will be sufficient to bring the DUP back into the Northern Ireland government.

However, the betterment of UK-EU relations is unlikely to have a significant impact on sterling, as it will not enhance the overall trading environment between the two entities. Instead, the macroeconomic and monetary policies of both will continue to be the dominant factors. The ECB appears to have a greater amount of tightening ahead of it compared to the Bank of England, which suggests that EUR/GBP will remain supported under 0.88. As for GBP/USD, it is susceptible to further gains by the US dollar and could see a move towards 1.1850 this week.

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