US: Disinflation revival is negative for the dollar – SocGen

Dollar strength in recent quarters has coincided with periods of higher US inflation expectations, and vice-versa and is apparent that the weakening in US inflation expectations since 1Q 2017 has helped to undermine the dollar, explains Alvin T. Tan, Research Analyst at Societe Generale.

Key Quotes

“Given the dependence of US dollar exchange rates on US bond yields and Fed policy expectations, periods of US disinflation will be damaging to the dollar. In this regard, the return of disinflationary pressures in recent months does not bode well for the dollar. Insofar as oil prices are affecting inflation expectations, falling oil prices are damaging to the dollar.”

“As for the euro, there is evidence that euro area (EA) disinflation has contributed to a stronger nominal trade-weighted euro exchange rate in recent quarters. Between November 2015 and July 2016, for example, a drop in the EA 5Y5Y breakeven inflation swap rate from 1.76% to 1.25% was accompanied by the euro appreciating by 5%. It is worth noting that during this period, the ECB cut its deposit rate from -0.20% to -0.40%, its main refi rate to 0%, and expanded its asset purchase programme. Yet the euro rose. In the most recent disinflation period starting in late January 2017, we have seen the euro climb almost 3% thus far.”

“There is much debate about the inability of US inflation and inflation expectations to rise despite a tightening labour market. There is clearly a global dimension to the current abrupt deceleration in inflation pressure as it materialised at the same time as in the EA. Regardless of the true reasons, the dollar will be hamstrung by the revival of disinflation pressures, while the euro is likely to benefit further. This supports our broader view that the trade-weighted dollar peaked in 1Q 2017.”