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Column: ‘Peak inflation’ ambiguous for dollar

The new-found “peak inflation” narrative has buoyed U.S. stock markets and lifted the dollar – but the durability of the more puzzling currency move relies more on how the inflation picture plays out beyond U.S. borders.

Outsize retreats in annual U.S. consumer and producer price inflation last month, due largely to ebbing crude oil and commodity prices, have encouraged investors to bet 40-year high inflation rates may finally have topped out and the U.S. Federal Reserve can ease off the monetary brakes over the next six months.

While that may appear to be speculative wishful thinking in the middle of such an uncertain period, almost 90% of global investors polled this month by Bank of America expect lower inflation over the next 12 months.

How much pain will be suffered in the interim – from cost of living squeezes, real wage cuts, higher borrowing costs or lost jobs – is a harder call. Despite the 25% bounce in Wall St stocks since June, fund managers remain gloomy on recession prospects and are still overwhelmingly bearish on stocks – even if slightly less that the previous month.

But how the inflation picture pans out around the world may be a better guide to dollar outlook. According to BofA’s survey, the “most crowded trade” this month remains “long dollars”.

The assumption appears to be that global recession and market stress will hurt most beyond America and force monetary authorities overseas to lag Fed tightening, or even face it down altogether – as in Japan and now China this week.

The Transatlantic comparison most relevant to the pivotal euro/dollar exchange rate, however, is more complicated.

Remarkably, U.S. consumer price inflation fell below the euro zone equivalent in July for the first time in almost seven years – despite the blinding natural gas price shock in Europe.

And, at least partly due to the more severe energy shock on European prices as well higher indexation of benefits and wages and more collective wage bargaining, the Organisation for Economic Cooperation and Development sees euro inflation staying above the U.S. rate through the end of next year at least.

The currency effect hinges on the extent to which the European Central Bank has the scope to offset relatively these higher euro inflation rates – either apeing Fed interest rate rises, or perhaps holding rates at higher levels for longer well after the Fed is already easing again.

However, economists emphasise the differences in the makeup of the U.S. inflation spike versus similar headline rate surges in Europe. Annual energy and food price gains have contributed about 50% more to the prevailing euro zone inflation rate than its U.S. equivalent, reflecting more modest underlying demand pressures as well as the shocking gas component.

That may give the ECB more leeway to see the spike in headline rates as temporary and comfortably temper its rate rises – but the structural impact on euro zone wages, indexation and subsidies may make mean it has to battle it for longer.

The swoon in euro/dollar to below parity in June showed how much the market doubted it has that leeway to be more aggressive. That was largely due the expected demand hit from the natgas price shock, possible gas rationing and pressure on euro budgets amid politically stress in Italy and elsewhere.

Even after the ECB’s surprisingly large half-point interest rate rise last month, the so-called market-implied “terminal” – or peak rate for the cycle – is still less than half that of the Fed. And this implied ECB terminal rate plunged almost a full percentage point from peaks of 2.5% hit from just before recession anxiety took hold around midyear.

Morgan Stanley’s Matthew Hornbach reckons there’s a great deal of bearishness about the outlook for the European economy but consensus forecasts compared to the United States still look “complacent” and pose a rise to euro/dollar pricing.
As with so much else, murky geopolitics and the related energy uncertainty make it hard to forecast.

The perceived gap between the stances of the two central banks is narrowing again in recent weeks, and this is one reason the “crowded” dollar trade stalled.

Spinning that out to relative nominal and real bond yields shows small moves but possible inflection points.

Although both close to their highest since 2019, the 2-year premium on U.S. bond yields over German equivalents has retreated 20 basis points this month and the real-rate equivalent has fallen back more than 10 basis points too.

And however it pans out from here, central banks outside the United States know a significant dollar retreat is itself a powerful boon the hopes of “peak inflation” worldwide.
Source: Reuters (by Mike Dolan, Twitter: @reutersMikeD Editing by Marguerita Choy)

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