FX Update: Week of August 29 – Dollar up as Fed warns the inflation fight will hit growth and jobs

Friday’s release of Core PCE Deflator for July was +4.6% YoY vs. forecast of 4.7% and prior month’s 4.8%. The Fed welcomed the reduction in its favored inflation measure but quickly added that one data point does not make a trend. The dollar ended trading stronger by end of day Friday but failed to reach Tuesday’s highs.

With 4% Fed Funds now priced into FX rates it may take an exogenous shock or an even more aggressive Fed to drive the dollar higher.

In March 2020, when the initial panic of the COVID pandemic hit, the pound traded at a low of 1.1555 to the US dollar. This morning GBP trades at 1.1708 which is the weakest since the pandemic lows. The Bank of England was the first central bank to openly forecast a recession that would last five quarters.  Uncertainty on three levels may contribute to further pound weakness: lingering Brexit concerns, political shocks and winter fuel costs.

Last week the euro traded at its lowest level since 2002 but then gained after comments from European Central Bank officials that a rise of 0.75% in the benchmark interest rate may be necessary. This Wednesday’s August CPI data carries a 9% forecast thereby providing the last key data point before next week’s ECB meeting (September 9). Read Here in SVB’s FX Quarterly Outlook about factors driving the euro to parity with the dollar.

The Russian/Ukraine war is felt globally but carries a potentially greater disruption to the European economy especially with regard to energy supplies. Both sides of the war are digging in for prolonged fighting likely resulting in continued pressure on the euro.

The Canadian dollar sits above the 1.30 level as FX markets see the Fed remaining more aggressive than the Bank of Canada. Powell warned of “below trend growth and softer labor markets” but intends to raise rates in the US anyway. Wednesday’s Canadian GDP may help inform the Bank of Canada’s next rate increase when it meets September 7.  See table below showing how the loonie has fared better than other currencies relative to FX Budget Rates.  The price of oil held up last week after Saudi Arabia warned production cuts may be necessary. OPEC has coalesced around $100/bbl oil whether Iran gets a nuclear deal or not.

The Japanese yen continues to trade at levels last seen in the late 1990s.  Despite Tokyo’s CPI data for August hitting 2.9% (up from 0.6% in January) the Bank of Japan is expected to stick to its highly accommodative monetary policy. Japan’s central bank’s benchmark interest rate is set at 0.1% with most other central banks raising rates putting constant pressure on the yen. Japan’s inflation is caused mostly by energy, commodity prices and the weak yen – all of which are considered by Bank of Japan to be temporary. Until inflation begins to show up in wage increases, the Bank of Japan is unlikely to raise rates and the yen is unlikely to see sustainable gains.