Dollar Gains on Slower Fed Easing, Inflation Outlook

The dollar index (DXY00) climbed to a 1-1/2 week high on Friday, supported by positive US economic data and month-end position rebalancing. The dollar found additional support from higher T-note yields. US July personal spending rose +0.5% m/m, right on expectations, while July personal income rose +0.3% m/m, stronger than expectations of +0.2% m/m. The US July core PCE price index, the Fed's preferred inflation gauge, remained unchanged from June at +2.6% y/y, better than expectations of an increase to +2.7% y/y. The US Aug MNI Chicago PMI unexpectedly rose +0.8 to 46.1, stronger than expectations of a decline to 44.8. The University of Michigan's Aug US consumer sentiment index was revised upward by +0.1 to 67.9, weaker than expectations of 68.1.

The markets are discounting the chances at 100% for a -25 bp rate cut at the Sep 17-18 FOMC meeting and at 31% for a -50 bp rate cut at that meeting. EUR/USD (^EURUSD) on Friday fell to a 1-1/2 week low and finished down by -0.24%. The euro edged lower Friday after Eurozone Aug consumer prices rose at the slowest pace in 3 years, a dovish factor for ECB policy. However, losses in the euro were contained after the Eurozone July unemployment rate unexpectedly fell to a record low, a hawkish factor for ECB policy. Also, comments Friday from ECB Executive Board member Schnabel were supportive of the euro when she said the ECB shouldn't lower interest rates too quickly. The Eurozone Aug CPI eased to 2.2% y/y from 2.6% y/y, right on expectations and the smallest increase in 3 years. Also, the Aug core CPI eased to 2.8% y/y from 2.9% y/y in Jul, right on expectations. The Eurozone July unemployment rate unexpectedly fell -0.1 to a record low of 6.4%, showing a stronger labor market than expectations of no change at 6.5%. ECB Executive Board member Schnabel said the ECB shouldn't lower interest rates too quickly as risks to inflation's return to 2% persist. Swaps are discounting the chances of a -25 bp rate cut by the ECB at 99% for the September 12 meeting. USD/JPY (^USDJPY) on Friday rose by +0.77%. The yen was under pressure Friday from weaker-than-expected Japanese economic reports. The yen extended its losses Friday after T-note yields rose. The yen found some support after Japan Aug Tokyo consumer prices rose more than expected, a hawkish factor for BOJ policy. Japan's July industrial production rose +2.8% m/m, weaker than expectations of +3.5% m/m. Japan's July retail sales rose +0.2% m/m, weaker than expectations of +0.4% m/m. The Japan July jobless rate unexpectedly rose +0.2 to a 17-month high of 2.7%, showing a weaker labor market than expectations of no change at 2.5%. Japan Aug Tokyo CPI rose +2.6% y/y, stronger than expectations of +2.3% y/y. Also, Aug Tokyo CPI ex-fresh food and energy rose +1.6% y/y, stronger than expectations of +1.4% y/y. Swaps are pricing in the chances for a +10 bp rate hike by the BOJ at 0% for the September 20 meeting and at +12% for the October 30-31 meeting.

In summary, the dollar's long-term strength is likely to be buoyed by the Fed's slower easing policy, as indicated by the median projection of a 1.8% annual GDP growth rate and a 2.0% unemployment rate by 2024. This suggests a resilient U.S. economy, which should support the dollar's value against other major currencies. However, the dollar's appreciation may be tempered by the projected 2.0% PCE inflation rate by 2024, which could limit the Fed's ability to raise interest rates aggressively. In comparison, the euro is expected to face headwinds, with a projected 2.1% inflation rate by 2024 and a slower economic recovery, as indicated by the median projection of a 2.2% GDP growth rate.