The Dollar Breaking Point

Last week, the Fed released its FOMC minutes, the protocol of the Fed's decision makers, and already it seems to have backfired. While the minutes thoroughly described how FOMC committee members have gradually shifted their projections on inflation and a lower Fed Funds Rate, comments that were supposed to gently assist in tilting the dollar lower have done the exact opposite.

FOMC Minutes Backfire

The Fed's statement contained two comments that were combined or written in such a way that investors immediately became wary of shorting the dollar. The first, was the remark on the fact that excess capacity and downward pressure in commodities was seen as winding down gradually thus keeping the Fed's long-term inflation target of 2% (or close to it) still intact. So far so good, yet the Fed also added a statement on what is holding back the possible rate hike and that is low energy prices and a strong dollar. In other words, the Fed outlined that a lower dollar would increase the chances of a rate hike. For investors, this meant shorting the dollar could turn more risky because with every instance of a lower dollar the likelihood of a rate hike from the Fed would rise which would create demand for the dollar and thus could hit dollar short sellers.

Once Again, Inflation

Market reaction was not too late in coming and investors were quick to crowd back into the dollar, pushing it higher vs most major currencies and especially the Euro. The question is why did investors chose to take the FOMC remark as a limited downside rather than a limited upside? Once again, this has to do with inflation. While headline inflation is currently 0%, Core inflation has held at 1.7%, fairly close to 2%. For investors, this is generally interpreted as US inflation is holding steady with a high dollar, thus any potential softness in the dollar could quickly push inflation higher. This is also reflected by the substantially higher yields of US treasuries as compared with similar debt instruments from the Eurozone. While US yields have been moving lower, Eurozone yields have similarly been moving lower.

What Could Break the Dollar?

The statement about the dollar's strength or weakness affecting the trajectory for inflation rates can be seen as a double-edged sword; it can limit downside potential for the dollar but can also limit to the upside if a stronger dollar is seen as curbing inflation. This means that while investors are now choosing to look at the Fed's statement as a limit to the dollar's downside they may, at any time, switch and view it as a limit to dollar gains which, of course, would propel the long-anticipated dollar correction. What could lead investors to switch sides and call a limit to dollar strength rather than the opposite? As you may have guessed, it is inflation. If inflation returns to slide, it will shift the consensus towards confirmation that a stronger dollar continues to curb US inflation and therefore, has reached its limit which could then break the dollar. Of course, as long as US inflation holds steady, and even if dollar holders become more uneasy, the dollar will not break, at least not yet.

Three Shades of Inflation

To really understand if, indeed, US inflation is heading lower, one most understand the various "shades" of inflation due to be released over the next week. First and foremost, it is CPI or the Consumer Price Index yet more specifically it is Core CPI which excludes energy and food components. At the moment, Core inflation has held steady at 1.7% after bouncing back from 1.6%, suggesting inflation is still here. Hence, Core CPI needs to hold or rise for investors to continue and maintain their near-term inflation outlook; with any fall in Core Inflation investors would tend to lower their inflation outlook. The second shade of inflation would be PPI or the Producer Price Index which measures the inflation gauge as experienced by manufacturers and producers. This index is indicative of the potential decline in prices. If the index continues to fall next week it will raise the risk of lower inflation in the mid-term. Yet for lower producer prices to be passed on to consumers and thus turn into lower inflation, one other thing needs to happen and that is that consumers need to spend less. And that brings us to the final shade of inflation that is due out next week and that is retail sales. I have continually pointed on weak retail sales as a risk factor for inflation and the dollar. If retail sales next week fall yet again, in combination with a fall in PPI, that could push investors to believe that manufacturers are about to lower prices which would lower inflation which could break the dollar. So is the dollar about to break? Thus far, truth be told, pricing action don't suggest it, but if the various inflation gauges next week begin to show that the strong dollar is weighing on inflation, the breaking point could quickly materialize.

Look for my post next week.

Best,
Lior Alkalay
INO.com Contributor - Forex

Disclosure: This article is the opinion of the contributor themselves. The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. This contributor is not receiving compensation (other than from INO.com) for their opinion.