The FX markets are abuzz with the latest developments, particularly the retreat of the dollar's debasement trade. This phenomenon, which had seen the US dollar's value depreciate due to the Federal Reserve's dovish stance, is now experiencing a reversal. The market's focus is on the upcoming US May CPI release, which is expected to show a rise in headline inflation above 4.0% year-over-year, a level not seen since May 2023. This, coupled with the anticipated core CPI increase of 0.3% month-on-month and 2.9% year-over-year, is fueling the market's belief that the Fed will hike interest rates in December, thus supporting the dollar.
One interesting aspect of this scenario is the potential impact on the core CPI release. The composition of the core basket, with shelter accounting for 45%, services at 25-30%, and goods at 20-25%, is crucial. Any signs that the loss of disposable income is affecting consumer spending in other areas could temper the hawkish Fed tightening scenarios. The pressure on rents, a significant component of the shelter component, is a key factor to watch. A 0.2% core CPI month-on-month reading could lead to a softening of the dollar, with short-dated rates potentially edging lower.
The rise in US real interest rates, which have increased by 60 basis points over the last six weeks, is a significant driver of the dollar's recovery. This has put pressure on the debasement trade, particularly in gold, bitcoin, and the Swiss franc. Key support levels in these assets are being closely watched, with any signs of further money leaving the trade and entering the dollar being a critical indicator. The USD/CHF pair is also a key vehicle in this debasement retreat, and the significant inflow of $99 billion into USD-denominated money market funds last week further underscores the dollar's strength.
Looking ahead, the DXY (Dollar Index) is expected to remain bid on dips, with upside risks to energy prices. A soft core CPI reading could see DXY test the 99.50/60 area, but the overall direction of travel points towards the 100.40/50 area into next week. The market's reaction to the May CPI release will be pivotal in determining the dollar's trajectory.
In contrast, the euro (EUR) is expected to consolidate in the lead-up to the European Central Bank (ECB) meeting. The market's expectation of a 25 basis point rate hike by the ECB, followed by a potential hike in July, is keeping the EUR/USD pair in a short-term trading range. A firm US CPI print might struggle to break the 1.1500 support level, especially with the potential for a hawkish ECB meeting tomorrow.
The Canadian dollar (CAD) is also expected to remain under pressure, with the Bank of Canada leaning dovish. Canada's economy is facing challenges due to trade and investment stalls, and the uncertainty around USMCA renegotiations and the potential for Alberta's independence referendum are adding to the sentiment. The Canadian dollar is likely to lag in the G10 space, with USD/CAD pressing strong resistance in the 1.3970/4000 area.
Lastly, the Czech koruna (CZK) is painting a bullish picture for the FX markets. The Czech National Bank (CNB) is expected to hike rates at the June meeting, with the decision potentially boosting the koruna as the start of a tightening cycle. The market's focus will be on core inflation, which is expected to remain stable, and the CNB's expectations, with EUR/CZK potentially testing the 24.00 level next week.
