Inflation data forcing USD to retreat

After weeks of speculation the long-waited U.S. CPI data was published on Tuesday. The data points did not offer any major surprises. Core inflation printed at 1.6% on a year-on- year basis and 0.6% on a month-on-month basis, the highest monthly rise since 2012.

Inflation has been a hot topic for weeks with UST 10-year yields signaling the market’s increased expectations, touching 1.77% in March, and the 10-year breakeven rate reaching a 8-year high of 2.37%. The narrative has been supported by a number of data points, including a successful vaccine rollout in the country, which has allowed for the re-opening of the economy and higher growth expectations. The latest Dallas Fed Mobility and Engagement Index indicates that around 70% of the country has re-opened as of February 2021.

Factors affecting CPI this month

Moreover, March manufacturing PMI exploded to 64.7 (versus the consensus expectation of 61.3), signaling there is an increased demand for goods, causing a ‘Bullwhip effect’ in the supply chains. A ’Bullwhip effect’ characterizes companies in supply chains that have depleted their inventories and are now struggling to meet increased orders from consumers who had been restricted from spending money due to lockdowns but now have received stimulus cheques from the government.

Additional strain on supply chains has been caused by COVID-19-related disruptions to global logistics infrastructure. The recent spectacle in the Suez Canal with a container ship blocking traffic for six days has only fueled the narrative that increased producer prices and consumer demand would manifest itself in higher CPI.

Increased commodities prices have also supported the expectation of higher consumer prices. Oil futures have gained roughly 25% year to date, whilst the CRB index is up 11%, although the prices have been moving sideways since early March. It should be noted that there is little evidence that higher commodity prices show up in CPI data. In fact, the approximate pass-through rate is about 15% into core CPI.

Lastly, better than expected jobs data in Q1 has added the last piece to the inflationistas’ narrative. With unemployment at 6% and 1.5 million jobs added in the U.S. in Q1, it might indeed seem that the labour market has recovered enough for wage pressure to pick up. However, dissecting the numbers, we see that the recovery has predominantly been in sectors that have benefited directly from the re-opening, such as retail, education, hospitality and leisure. Those are also the sectors that tend to be lower paid and suffered the most job losses last year. As such, there is little wage pressure expected until high skilled (and high paid) sectors recover to the extent that focus will shift from automation to hiring more people. Automation, in essence, is increasing productivity, which tends to be disinflationary instead.

Breaking down US CPI in March

The Federal Reserve Bank Chair has addressed the markets on numerous occasions, emphasizing that the pickup in CPI (or PCE, the Fed’s preferred measure of inflation) is nothing but transitory. The Fed is clearly on to something. Looking at March data, CPI print seems mostly reflective of re-opening. And this analysis even takes into consideration base effects where the year-on-year comparison is against an extremely weak March 2020 when the entire world was locked down.

When deconstructing core CPI, it becomes evident that the narrative hardly supports higher consumer prices. Housing contributes around 42% to the total index with transportation adding 15% and medical care 9%. These figures make it rather obvious that pressure on CPI through the aforementioned variables is minuscule. There are still around 8 million unemployed Americans and another 9 million who are underemployed who have little incentive to procure more expensive housing. Moreover, the trend of leaving big coastal cities in favour of more affordable suburbs and smaller towns should not translate into higher prices paid on housing on a durable basis.

Data published on Tuesday shows that the gain in monthly core inflation was mostly supported by an increase in the services index adjusted for energy (+0.4%), whilst the housing subcomponent was up 0.3%. The transportation sub-component rose 1.8%, after a negative 3-month period starting in December 2020, a clear sign that the economy is re- opening. Furthermore, the medical care sub-index gained a modest 0.1%, the lowest since December 2020.

Commodities adjusted for food and energy index was up 0.1% in March, after a mostly flat 5-month period. Used cars components rose 0.5% in March, after four consecutive months in the negative. New car components remained flat for the second month in a row. The apparel subcomponent shed -0.3%, its second consecutive loss.

The yearly increase of 1.6% in core inflation was largely supported by a gain in housing (+1.7%), used cars and trucks (+9.4%) and medical care (+1.8%).

Looking at the data, it seems the re-opening narrative indeed manifests itself in CPI. Cyclical components have picked up at the back of people becoming increasingly mobile again with around 23% of Americans being fully vaccinated. The pressure on transportation and housing prices are critical for future CPI print. For sustained inflation we need to see general durable price level acceleration. With no more direct stimulus to individuals on the horizon, labour market recovery with ensuing wage growth remains the critical variable for future inflation.

March CPI’s effect on the USD

U.S. dollar index responded to inflation print by shedding -0.28%, closing on Tuesday near 79% Fibonacci retracement level 91.83. The downward pressure continued on Wednesday with price sliding another 7 basis points to 91.76, at the time of writing this report.

Price is now below short-term moving averages (MA), as well as below 200-day MA. The next support level is near 50-day MA support near 91.57. Short-term MA-s are currently roped and not giving a clear direction about the trend on the daily chart, although price is oversold based on Stochastic, and a pullback to 92.0 levels is likely.

Price has been finding support 8-day and 21-day MA since the beginning of this bullish swing early in March, signaling that strong upward momentum has prevailed. Should the 50-day MA support hold, we would expect the bullish trend to resume and price test 94.0 level.