Summary:

• Friday’s data on inflation crucial for the FX market
• The US dollar recovered from a sell-off on Wednesday 
• EURUSD still locked between the key levels

The US dollar is really fighting an uphill battle. Just when it looked as if it was on a tear, it was hit by rumour on China considering limiting its exposure to the US bonds. It’s a broad an complicated topic that in our view will have more long than short term ramifications. In a short term USD bulls clearly need an impulse and they will be looking for the data on inflation this Friday. 

Will low exposure help?

The US dollar could be looking tactically oversold on some metrics. One of the is speculative positioning that is roughly neutral and lower than a 3-year average. That is in contrast to the euro, where the positioning is at the all time high and in theory could make a dollar more responsive to positive surprises. Moreover, the greenback clearly lagged changes in yield spreads. When looking at a correlation that prevailed for much of 2017 between EURUSD and 10-year bond yield spread, the pair would be much lower. 

Speculative positioning on the USD is relatively low but the currency remains overvalued against a long-term real rate. Source: XTB Research 

Then again, the dollar is way above the 10 and 20 year averages in real terms and investors need good reasons to buy it again. 

Inflation has been a balast…

Yes the Fed is tightening the policy but the market is betting it will have to slow down unless inflation accelerates. Headline inflation in the US was 2.2% y/y in November but that’s only in theory higher than the FOMC target of 2%. Unlike other central banks the Fed is looking at the PCE not the CPI inflation and the other measure shows a lower dynamics (1.8% y/y in November) because a housing component has a far lower weight here. Furthermore the Fed is looking at the core measures that omit volatile energy and food prices and here the picture is even more grim – 1.7% for the CPI and 1.5% for the PCE. If that wasn’t bad enough, the monthly pace over the past few months was close to 0.1% which would produce annual inflation of just 1.2-1.3% unless there’s some improvement.

Key inflation metrics are below Fed’s target of 2%. Source: Macrobond, XTB Research 

So what to look for on Friday? Investors will only get the CPI data, the PCE will be released at the end of the month. Because of relatively high inflation at the end of 2016, there are 2 more months of “high base”. This means that core CPI is unlikely to improve on the last 1.7% y/y print and indeed such figure is expected again. What is important is m/m reading which should be at 0.2%, anything lower than that would signal weak inflation. 

Investors should pay attention to the core CPI data on Friday. Source: xStation5 

EURUSD locked between 1.19 and 1.21

In the alert from last week we pointed out at a possible double top formation that indeed looks realistic. Despite the “Chinese” blow the EURUSD failed to move above 1.20 again but a support at 1.19 holds firm. It is therefore obvious that a positive impulse is necessary for this zone to break and allow for the materialization of a double top formation. 

A double top of EURUSD remains a possibility but sellers need to break the key 1.19 zone in a near future. Source: xStation5