Week ahead: Will the Fed lend a helping hand to the USD? Focus on Aussie CPI

US dollar continued to bleed this week as markets, hitting the lowest level since mid-June 2016 against the basket of currencies. The US Eco calendar was light, thus USD was a casualty of overseas forces, mainly the ECB. 

To be fair, Draghi did his best to avoid further appreciation of the EUR. However, markets have realized that QE taper is a necessity and not a matter of choice. Hence, even the most basic forward guidance that the policy could be reviewed in the months ahead sent the EUR higher across the board. EUR/USD jumped to 1.1677; the highest level since Aug 2015 (1.1713 - Remember Yuan devaluation & the flash crash in Dow?)

Dollar Index is oversold… closely follows 10-year yield

The Dollar Index (DXY) is extremely oversold if we take into consideration the 14-day RSI. The weekly RSI has hit the oversold territory as well. This should not come as a surprise, given the index is set to end lower for the fifth straight week. 

The chart above also shows the USD closely follows the 10-year treasury yield

• A = the steeper the yield curve the stronger the USD and vice versa
• B = higher the inflation expectations, steeper is the yield curve and vice versa

So it can be concluded that the fate of the USD is almost entirely dependent on the inflation expectations. It’s all about inflation differential… 

Inflation is falling

In her testimony earlier this month, Yellen expressed concerns regarding inflation, but maintained that the slowdown was only “partly the result of a few unusual reductions” in certain parts of the consumer price index. This was the less confident wording than the Fed has used in the past.

The Fed’s preferred measure on inflation - core PCE price deflation does show a slowdown- 

Given the slowdown in inflation, one may expect the Fed to change the language, although a significant majority in the market believes the Fed is on-auto pilot to raise rates and will also reduce its balance sheet starting this September at a level of $10 billion per month. 

Why so?

It is no longer about inflation as we have seen with respect to other major central banks. It is about undoing what has not worked for so long. The Bank for International Settlements (BIS) warned in late June that the global financial stability will be in jeopardy if low inflation lulls central banks into not raising interest rates when needed. 

Fed too in the recent past has expressed surprise that financial conditions continue to ease despite rate hikes. It has talked about over valuation in the equities…

Thus, it is quite likely that the Fed would largely refrain from going dovish. Markets do not expect the Fed to raise rates in September and November. 

The probability of the December rate hike stands below 50%. This is due to fears that the Fed may delay tightening. If the Fed downplays the drop in the inflation, the USD may witness a technical recovery, although it could be short lived/another opportunity for the bears to kill the USD as the yield curve is likely to steepen only if the inflation expectations pick up. 

EUR/USD - 1.18 is on the cards

Monthly chart

A nice bullish RSI divergence and an upside break of the falling channel suggests the pair is on track to test its downward sloping monthly 50-MA of 1.1889. A minor pullback 1.15-1.1460 could be seen if the Fed ignores the drop in inflation. 

AUD/USD eyes monthly 50-MA

Aussie rose to a high of 0.7988 and may test 0.80 handle if the USD selling gathers pace in the NY session. RBA’s Debelle did his best to talk down the Aussie dollar in the Asian session today. However, the fresh bids below 0.79 ensured the pair is back to 0.7920 levels. 

One thing is clear - the RBA isn’t comfortable with the rising AUD. A drop in the inflation could become the reason to jawbone the Aussie even more in the coming weeks. 
Australia CPI is due for release on Wednesday. A weaker-than-expected figure could yield a technical correction to 0.7820-0.7750 levels. On the other hand, the currency would rise to 0.8070 (monthly 50-MA) if the inflation betters estimates.