U.S. Dollar Rally Runs Dry Amidst Fading 'Short-Squeeze' and U.S. Inflation Rethink, but still too Soon to Call its Demise

- Dollar momentum stalled by previous week's inflation data miss

- Société Générale say recent Dollar strength nothing more than result of positioning

- But, analysts weary of calling end to the Dollar's run higher

Dollar exchange rates

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The U.S. Dollar is on the back-foot at the start of the new week - analysts give their views on why this is and whether we have witnessed the end of the currency's recovery.

The Dollar remains a dominant force on global financial markets having registered gains against the group-of-ten major global currencies over the past month to date, and key to the outlook is whether the Dollar can reassert its strength.

For now, consolidation appears to be the theme as the Dollar's fading strength allows the likes of Sterling and the Euro to retake some lost ground and build potential bases.

"USD momentum has crucially stalled somewhat helped by the US inflation miss last Thursday, and as the US 10Y once again failed to make a firm break of the 3% level last week," says a foreign exchange strategy note from Danske Bank.

"The USD’s sharp and broad-based rebound that has dominated markets since mid April, seems to have stalled in the near term. Stabilisation in risk sentiment, soft US wage and core inflation data, cleaner positioning and the rapid pace of the USD appreciation raise risks of a near-term retracement," says a note from the corporate dealing desk at Barclays.

The Pound-to-Dollar exchange rate has risen to 1.3582, and as we note in our week-ahead forecast the pair is trying to form a base from which to potentially recover.

The Euro-Dollar exchange rate is seeing similar price action, with analysts waiting to see whether a recent rebound is able to deliver more substantive gains.

For now, under current market conditions, the outlook for these pairs still ultimately rests with the Dollar.

"The inability of US yields to push higher, the continued absence of signs of an inflation pick-up and the tension seen in emerging market and equity markets, all continue to support the view that recent Dollar strength is nothing more than a sharp short-squeeze," says Guy Stear, an economist with Société Générale in Paris.

There appear to be three distinct, yet ultimately interlinked, issues at play here: 1) the short-squeeze, 2) inflation and 3) yields.

1) Regarding the short-squeeze, selling the Dollar and buying Euros and Sterling was a favoured position on currency markets for much of 2018, so much so that positioning was clearly crowded and at risk of a reversal. It appears that the recovery in the Dollar has flushed out these gorged positions and the market might be finding more balance.

2) Inflation data last week disappointed Dollar-bulls. US core CPI missed analysts expectations by reading at 2.1%, while monthly headline inflation missed expectations with an increase of 0.2%. One of the key drivers of the Dollar recovery was the view that U.S. inflation was hotting up than elsewhere in the world, and this would in turn trigger yet more rate rises at the U.S. Federal Reserve. This latest data invites questions to be raised on this theory.

"Thursday’s softer than expected US CPI caused some kind of change in the mind-set on global markets. The report was close to consensus, but convinced markets that the Fed won’t change its gradual path to policy normalisation. This slowed the rise in US yields and in the dollar and supported equities," says Piet Lammens, an analyst with KBC Markets in Brussels.

3) For the Dollar, it appears a newfound focus by markets on moves in the yields on US Treasury bonds are key (this focus is in turn ultimately partly due to the above-mentioned inflation picture, so there are interlinkages).

The 10-year bond yield touching the 3% marker appears to have catalysed something of a regime shift in global financial markets; one that favoured the Dollar.

Should yields continue to move higher, the Dollar might do too. And, behind the rise in US Treasury yields and the Dollar is the continued robust performance of the US economy and inflation which in turn lead to expectations for yet more interest rate rises at the US Federal Reserve.

A further point to note on this is that rising ten-year yields are not necessarily guaranteed to always be a pro-Dollar story.

"While US yields are on the rise with the 10Y again flirting with 3% and supporting USD, we note that the continued US curve flattening is a looming USD negative in making US Treasuries less appealing from a ‘roll’ point of view," say Danske Bank.

Flattening refers longer-dated yields no longer offering a greater return than shorter-term bond yields, this often suggests the longer-term prospects for the U.S. economy are not altogether as optimistic as they once were as longer-term inflation expectations are pared back.


But, the Dollar's Run Might not be Over

So while the drivers of the Dollar's strong performance over recent week appear to have faded somewhat, analysts are loath to call the end of the rally.

"While positioning has seemingly been cleaned up somewhat in the latest move lower in EUR/USD, we still see a case for a better US cyclical position and the rising carry on short positions to pave the way for renewed downside near term; good support seen at the Dec-17 low of 1.1718," say Danske Bank.

And Soc Gen's Stear adds, "that doesn’t mean that the EUR/USD correction is complete (it’s premature to dive in yet just because the Euro bounced on Friday) but it does support our belief that the Euro will in due course resume its uptrend, and the Dollar resume its downtrend."

So this could well be a wait-and-see week for global FX.

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