The US dollar has gone on a tear in recent weeks amid signs that the US economy remains resilient, in contrast to Europe and China that are rapidly losing steam. Whether this rally continues or suffers a setback will depend on the latest CPI report on Wednesday at 12:30 GMT. Overall though, the outlook for the dollar seems quite bright.
American strength
A range of incoming indicators continue to reaffirm the power of the US economy. The labor market is still in great shape and with inflation cooling off, real wage growth has returned to positive territory, which is a blessing for American consumers if it is sustained.
Meanwhile, the housing market has defied the negative pressure exerted by sky-high borrowing costs and has instead enjoyed an impressive recovery. Thanks to a national supply shortage, home prices as measured by the Case-Shiller price index almost hit new record highs in June, a trend that almost certainly persisted over the summer.
Add it all together and it seems US economic growth is reaccelerating. The economy grew by 2.1% year-over-year in the second quarter and the Atlanta Fed GDPNow model points to an annualized growth rate of 5.6% this quarter.
In contrast, both the Eurozone and China are slowing down at an alarming pace. Euro area GDP grew only 0.5% y/y in the second quarter, and business surveys suggest the situation will get worse moving forward, putting the risk of a mild recession on the radar. Likewise, China is dealing with the crises in its manufacturing and property sectors, which have sapped growth.
Inflation report
Turning to the upcoming releases, inflation as measured by the CPI rate is expected to have risen in August, partly because of the spike in energy prices. In monthly terms, the headline CPI rate is anticipated at 0.5%, which would push the yearly rate up to 3.5% from 3.2% in July.
However, the core rate that excludes energy and food items is projected to have risen only by 0.2% on the month. That would translate into a decline in the yearly rate, mostly because of base effects. Since a very hot print from August 2022 will now drop out of the 12-month CPI calculation and will be replaced by a colder print, that will mechanically push the yearly rate down.
Therefore, it’s a mixed bag and the market reaction will boil down to any surprises in these numbers. In this sense, the risk of an upside CPI surprise seems greater, as the prices paid components of both the ISM surveys rose sharply during the month.
Arguing the same point is the Cleveland Fed’s inflation nowcast model, which points to monthly prints of 0.79% and 0.38% for the headline and core CPI rates respectively, far above official forecasts. Admittedly, this is a narrow model, so it’s difficult to put much weight on it. Still, it is one of the only real-time inflation trackers available.
Looking at the charts, an upside CPI surprise could push euro/dollar lower towards the crucial region of 1.0630, a violation of which would shift the technical outlook to negative. On the other hand, the most important area to watch in case of a CPI miss is 1.0760, which acted both as support and resistance this year.
Big picture
All told, the US economy and by extension the dollar seem much more attractive than any alternatives at this point. Europe and China are battling a severe slowdown, the Japanese yen has been devastated by rate differentials, and the British pound is trading like a proxy for equity markets, leaving it vulnerable to any shifts in risk appetite.
The US dollar stands in antithesis to all this. It offers a combination of solid economic growth, high interest rates, and safe haven qualities thanks to its reserve currency status, making it an ‘all weather currency’.
If these elements remain in play while the global economy continues to struggle, that would leave plenty of scope for the dollar to extend its rally.
