Core PCE data to highlight the dollar resurgence chances

Rising yields a warning sign for markets

Market sentiment has been taking a turn for the worst of late, with US equities particularly feeling the pinch. This has a footing in interest rate expectations, with the FOMC minutes highlighting the willingness to continue pushing rates up upwards in a bid to combat inflation. It is a curious time for traders, as they attempt to ascertain how markets will approach each piece of news. By and large, the market outlook is based on inflation. If inflation is moving sharply lower, then traders are allowed some optimism around strong economic data. However, the slowdown we have seen in US disinflation instead provides a backdrop where each positive economic reading is seen as a source of greater concern given the perception that it allows the Federal Reserve more room to tighten without risk of economic collapse.

As ever, the US 10-year yield provides us with a very useful gauge of market perception, with the muted pullback seen in comparison to the dollar signalling the risk of another risk-off move ahead. The negative correlation between the dollar and the 10-year yield is clear, but the disproportionately smaller pullback does highlight a feeling that we could soon see a risk-off move come into play. With the US 10-year seemingly having bottomed out here, there is a strong case for a resurgence in the dollar which looks oversold. However, much of this comes down to the continued slowdown in the rate of disinflation. A strong move lower for inflation raises hopes of a swift return to easy monetary policy from the Fed. However, flatlining or rising inflation poses a significant risk that the Federal Reserve will need to push rates higher for longer in a bid to bring price growth back down to normal.

This afternoon sees the latest PCE inflation release, with markets forecasting a decline from 5% to 4.8%. The key core reading will be closely followed, given that it is so closely followed by the Fed. Markets predict a figure of 4.3% from 4.4%. While the annual figures are important, it can be useful to track monthly inflation as a gauge of where things are moving. The chart below highlights how pre-Covid inflation saw a monthly core PCE figure averaging 0.15%. That highlights how last month’s MoM figure of 0.3% does signal the continuation of above-target core inflation. Current forecasts signal another monthly figure of 0.3%, which would provide a warning sign that the new normal is double that seen pre-Covid. A 0.3% figure would annualize to 3.6%, which stands well above the 1-2% core PCE norm seen back in 2019. With that in mind a figure of 0.3% or above on the monthly core PCE reading would likely bring further risk-off gains for the dollar, while a figure below that could act as a drag on the greenback.

Looking at the dollar index, we can see that price has pushed up through the 76.4% Fibonacci resistance level. This is a warning sign that we could see a bullish reversal coming into play. In particular, a rise through 105.37 would end the pattern of lower highs, bringing about a more significant bullish break for the dollar.