US inflation spiked higher yesterday. There is uncertainty over what this could mean for Federal Reserve monetary policy. A decisive impact on the US dollar (USD) and major forex pairs have yet to be seen. However, Treasury yields are falling once more and this does not bode well for USD. We take a look at what this could mean for major pairs.
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US inflation spikes, higher than expected, but the market looks the other way.
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Treasury yields now falling with US 10 year at a 3 month low, “real” yields also breaking lower.
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What to look for in EUR/USD and GBP/USD to suggest a USD breakdown.
US inflation spikes to multi-year highs
Headline US CPI spiked to 5.0% year on year (highest since 2008) with core CPI (which strips out the volatile food and energy components) increased to 3.8% (the highest since 1992). These readings also come in above market expectation.
However, a big portion of this increase was apparently due to a spike in used car prices. This is just one example of the one-offs that are distorting inflation as the base effects of the early months of the pandemic in 2020 take hold.
It is why the Fed continues to look past inflation data spikes as being “transitory”. The market also looked past it (see below). However, we are still mindful that these eye-popping inflation rises will need to moderate fairly quickly as Q3 turns into Q4.
Bond yields falling will prove to be USD negative
As we touched on earlier, markets appear to have looked past this. Spiking inflation would be expected to drive investors to sell bonds (and therefore move yields higher). However, the US 10 year yield has fallen to a three month low. This move now threatens further downside back towards the 10 month uptrend (currently 1.23%).
We can also see that this downside break has come with a move higher in inflation expectations (measure by the US 10 year Breakeven rate). This means that bond yields adjusted for inflation (the "real” bond yield) has fallen sharply. US 10 year Inflation-Protected Securities are threatening to break down from a range once more.
When “real” bond yields fall it is negative for USD. Traditionally, there is a strong positive correlation between USD and real yields.
For now, the Dollar Index is holding up well (probably because EUR is struggling to find positive traction in the wake of a dovish ECB yesterday). However, if US real yields continue to fall then USD could come under increasing selling pressure once more.
The technical analysis outlook for EUR/USD and Cable is mixed, for now.
Let’s start with a look at EUR/USD. After the ECB meeting yesterday, the continued dovish outlook and insistence of it being too early to talk about tapering means that EUR is struggling.
EUR/USD is already beginning to form a new downtrend of lower highs. For now, there is no sign of USD weakness. If anything EUR seems to be coming out worse from yesterday's two key announcements.
The seems to be a bias more towards key support at 1.2104 right now. For any resuming USD weakness to be taking hold we are now watching this week’s lower reaction high at 1.2217. An upside break would re-open 1.2265 once more.
As has been the tendency in recent months, our strategy has been to buy GBP/USD into weakness. With the USD negative implications of falling US bond yields, we see no reason to change our strategy on Cable.
Any corrective move into the trend support and band between 1.40/1.41 we now see as an opportunity to buy. Momentum indicators look strong to buy into weakness and we favour upside pressure on 1.4240 resistance and above in due course.
Conclusion
If US bond yields continue to fall, this will increase the negative pressure on the US dollar. Whilst the outlook for EUR/USD is looking fairly mixed still, we believe that GBP/USD is a pair to play this dollar weakness through.
