Just about every currency posted gains during the US afternoon yesterday

Outlook

Just about every currency posted gains during the US afternoon yesterday, even the CAD , peso and yuan. We never know what traders were thinking and stories are usually made up to match coincidental developments as though they are causal.

First up is the big drop in yields. This gets attributed to the stock market partial recovery siphoning off cash. Another idea is that since PCE inflation was as expected, that somehow makes the Fed less hawkish going forward. This happens quite a lot and we still don’t understand it—the absence of a nasty surprise is somehow a positive.

Then there is the price of oil, with both WTI and Brent flirting with pre-war levels. This is considered to cut the immediate demand for dollars.

You can spend/waste weeks trying to find reliable correlations of dollar/oil and  dollar/equity index. Once upon a time for a brief time, the CAD was correlated with oil. The only correlation with lasting power over the years is dollar/yield differentials. For most of the past 25 years, the dollar has been inversely correlated with oil and the S&P, but that relationship, broke down about 10 years ago. We wrote about it at length. If the S&P and Nasdaq are going into correction mode, we can’t count on it benefitting the dollar (even if yields go up, since no NEW dollars are needed).

Even the dollar/gold correlation is wonky now. Given the new inflation data, gold “should” be higher but the recent gain is not impressive.

Today we get May trade in goods and the University of Michigan final June consumer confidence. Remember, the Michigan surveys consult only a few thousand persons and should be deemed inadequate. Besides, the ordinary person is completely ignorant of economics, so what he thinks is completely irrelevant. Economists, including Fed economists, think consumer sentiment drives spending in the immediate future. If the consumer sees inflation rising, he spends today to get ahead of it. This seems logical but the relationship is not well demonstrated.

Forecast

If we are getting a correction, we have to expect the dollar rally to resume. The “reasons” for the pushback are weak, especially the idea that since US inflation  came in as expected, the Fed may lose its hawkish tone.

On the purely mechanical basis, future headline inflation data will fall on falling oil prices, but that doesn’t much affect core, which excludes both fuel and food. Therefore, projecting a drop in inflation on oil prices alone is not a good idea.

Having said that, traders cherry-pick data to suit what they want to do in the first place. The correlation has returned—but don’t count on it lasting.

There is one more factor we need to consider—today is Friday and traders reduce positions. Also we get payrolls next Thursday, one day ahead of schedule due to the July 3 holiday. A good number reinforces the dovish Fed idea. We think it’s a silly idea but it seems to be gaining traction, Warsh’s words notwithstanding. Bottom line, the correction could go further than it now seems.