FX Update: USD rally done or just a tactical knock-out?

FX Trading focus: USD key reversal day?

Yesterday was an important day for the US dollar on the twin test from the latest US CPI release and the FOMC minutes, neither of which was able to support the greenback after a misleading knee-jerk boost to the greenback in the wake of the CPI release. In that release, the core CPI was in line with expectations of +0.2% month-on-month and +4.0% year-on-year (unchanged from Aug.), while the headline was +0.1% above expectations for both at +0.4% month-on-month and 5.4% year-on-year. The odd treasury sell-off and modest USD rally in the wake of the data release was perhaps driven by a focus on the shelter-related inflation in the report that will likely drive at least some persistence in the near term as rent levels rise with a lag to home prices, which have soared in the wake of the pandemic outbreak last year. Later, another strong US treasury auction, this time of the longest 30-year T-bonds saw long US yields falling lower still after the fall in yields on Tuesday, helping to drive a boost to risk sentiment in the highest flying and interest-rate sensitive equity sectors and taking the USD down several notches.

Later still, the FOMC minutes failed to jolt forward Fed expectations. The inflation discussion was very centered on whether inflation would prove transitory and still linking that with supply constraints that were forecast to ease, even as some Fed officials fretted sustained inflationary pressures. On the policy front, the minutes largely confirmed market expectations for the QE taper time frame. with the discussion suggesting a mid-November to mid-December starting point on an "illustrative example” pace of the tapering of $10 billion/month in US treasuries and $5 billion/month in MBS, which would mean eight-months to reach the zero balance sheet expansion steady state. The minutes seemed to indicate room for flexibility, however, on an “outcome-based standard”, while “several participants” felt the base case pace of tapering was too slow.

By the way, a compelling op-ed in the FT (paywall) from the redoubtable Stephen Roach published yesterday argues that we are risking an ugly 1970’s style stagflation due to supply chain constraints that are poorly addressed by the Fed’s extremely ponderous “sequencing trap” in which it must slowly exit tapering before considering interest rate hikes, which only operate with a significant lag, all while inflation risks rushing higher still as the economy is supply-side constrained relative to strong demand and is likely to remain so on insufficient output capacity and the push for reshoring production (which arguably is merely in the planning phase). To that I would add the shortage of skilled and even unskilled workers. As Roach says “As brilliant and lucky as they have been, today’s generation of central bankers is afflicted with the same sense of denial that proved problematic in the 1970’s. Due to a lack of experience and institutional memory of that tough period, the risk of another monetary policy blunder cannot be taken lightly.”

As for the US dollar reaction to all of the above, yesterday has proven at least a key reversal in a tactical sense and now we must see whether it marks a key reversal in the cyclical sense. The beginning of the latter would start with a sharp impulsive rally back clear of 1.1650-1.1700 in EURUDS and perhaps 0.7500 in AUDUSD as discussed in the chart below.

Chart: AUDUSD
AUDUSD is particularly interesting here for a number of reasons, including the contrasting concerns related to Chinese growth (AUD negative) even as metals and coal prices soar (very AUD positive). As well, Australia is set to end its lockdowns and could be set for a significant bounceback, together with a reflationary rebound that will eventually require that the RBA trips over its currently too-dovish forward guidance. From here, I will watch the critical 0.7400-0.7500 zone, which was pivotal on the way down, and where resistance was found near 0.7475 on the prior rally. Speculative positioning in the US currency futures market is at a record short as well, so if a sentiment shift is  underway here on inflation and a significant new upside outlook for the entire industrial metals space, there is considerable potential for a squeeze.