Forex Fundamentals

US Dollar. The US dollar’s rally over the past month has become extremely overextended and the market is finally beginning to feel it.

After yesterday’s sharp movements in the
commodity and stock markets, today’s theme has been retracements. Oil and gold
prices are both slightly higher, along with the Dow. In the FX markets, the buck
has sold off even though today’s US data is more dollar positive than negative,
purely because buyers are starting to become scarce ahead of critical resistance
levels. Inflation is the Fed’s primary focus, which made today’s report on
consumer prices even more important. Headline prices rose 0.4 percent while core
prices rose 0.3 percent, which was slightly stronger than expected. Although it may
seem like only a mild up tick from the 0.2 percent forecast, the three month
annualized rate of core inflation, the number that Bernanke is keeping an eye on,
hit 3.8 percent, the highest level in over a decade. This strong pace of growth has
sent rate hike expectations to 100 percent, with the market already beginning to
price in a tiny chance for another hike in August. However, a closer look at the
report shows that a large part of the rise was due to the higher cost of owners
equivalent rent. The pickup in mortgage rates has made renting a far more
attractive option than owning. Bond yields has risen as traders price in higher
rates, but at the same time the yield curve has inverted further, indicating that
the market believes the higher interest rates will have a big impact on growth.
Even though the rise in owners equivalent rent is an immediate inflationary concern,
it is also a longer term headache. The higher mortgage rates rise, the more risks
it poses for the housing market. The Fed’s Beige Book is already showing signs of
this impact as many of the districts report slower growth and higher inflation. Yet
the Fed has chosen to focus exclusively on the inflation component at the risk of
growth. This is a dangerous game to play, but with such solidarity behind their
decision to unanimously tell the markets that another quarter point rise will be
coming in June, it is a message that we cannot ignore. Therefore until the next
meeting, even if we do see the dollar give back more of its gains, it will probably
not come close to 1.30 in the EUR/USD as the fear of how far the Fed will go keeps
dollar bears cautious of taking on new positioning. Meanwhile tomorrow we are
expecting the TIC data, also known as the report on net foreign purchases of US
securities. Talk of reserve diversification over the past few months could bring
about a weak number, which would extend the dollar’s losses.

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