Inflation slowed. Stocks surged & the USD sold off. What’s next?

The US dollar dropped sharply against the major currencies after the positive inflation report. The consumer price index fell to 8.5% YoY vs. the forecast of 8.7%, down 0.6% from June. Data is encouraging as it suggests inflation will moderate from the June peak of 9.1%. After all, we could not say inflation was close to the end until we got the peak behind us. As the Fed can be data-dependent when it considers its next move, a 50 bps Fed hike vs. 75 bps is fully priced-in with expectations that Fed can ease its rate hiking. If the September inflation report continues with softening pricing pressure momentum, it may lead to a less hawkish Fed going forward, which would further lead to a reversal in the USD (weaker).

GBP/USD rallied as US inflation data was better than expected, but the recession fear, increases in the energy bill, and the race for UK prime minister left GBP more vulnerable. The Bank of England raised the interest rate to 1.75% this month with estimations of a deep recession later this year alongside 13% inflation. Liz Truss, British Foreign Secretary, is currently the favorite to become the next prime minister, and she believes her tax-cutting plan can help the cost-of-living crisis.

EUR/USD extended its gain but still has potential for sharp moves in either direction due to the inflation concerns. To prevent divergence in borrowing costs and a sovereign debt crisis within the eurozone, the new Transmission Protection Instrument (TPI) lets the ECB buy bonds from indebted countries to keep bond yields and spreads under control. The anti-fragmentation tool is working – the spreads among 10Y yields are in the acceptable range. On top of that, after delivering a 50 bps rate hike in July, the market expects a 50 bps rate hike in September, bringing the ECB’s primary rate to 0.50%.

Broader USD weakening has been supporting CAD's value despite softening oil prices. The Bank of Canada hiked the interest rate to 2.5% last month, resulting in a borrowing cost surge that weighs on mortgage demand. Market's expectation of 100 bps rate hikes by the end of this year has not changed, and the country’s economic growth is estimated to slow to 2% in Q3, from 4% in Q2.

JPY strengthened against the USD following the US inflation report, but the overall risk-on sentiment could potentially eat away the gain as JPY is viewed as the safe haven asset.  

In response to Nancy Pelosi’s visit to Taiwan, China expanded drills and new trade blocks against Taiwan marking a political warning against outside interference over the island. Last Thursday, Taiwan held defensive military drills. The ongoing military exercises and "possible invasion" could cause shipping lines to shut down or reroute, which would be problematic for trade flows around the world.