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US Dollar Hands Back Thursday's Gains after Mixed June Inflation Report

-USD slips after mixed inflation numbers, as political tensions linger. 

-Inflation rises further above Fed target but won't change policy - yet.

-Fed tolerance of inflation "overshoot" means no cigar for the USD.

© Robert Cicchetti, Adobe Stock

The US Dollar handed back earlier gains Thursday as traders responded to a mixed set of June inflation figures while maintaining a steady bid for the currency as President Donald Trump attends the latest North Atlantic Treaty Organization (NATO) summit amid heightened tensions over international trade.

Headline US inflation rose by 0.1% during June, down from 0.2% in May and beneath the consensus for a steady 0.2% reading last month, although this was still enough to push the annual rate of inflation up to 2.9%.

Core inflation, which removes volatile food and energy items from the goods basket and so is seen as a more reliable measure of domestically generated inflation pressures, rose by 0.2%. This pushed the annual rate of core inflation up to 2.3%, from 2.2% in May.

"Energy prices provided a slight downside miss versus what the consensus was pricing in for the month, but have done much of the work to raise headline inflation recently. A trend-like monthly gain of 0.2% on the core measure left it tracking 2.3%, also a tick faster than what was seen in May. That should have the Fed's preferred measure of inflation, core PCE prices, still tracking the central bank's 2% target," says Royce Mendes, an economist at CIBC Capital Markets.

Both sets of numbers are above the 2% inflation target of the Federal Reserve although there is uncertainty around the impact they are likely to have on the US Dollar given the Fed has signalled to markets that it is willing to tolerate an overshoot of the target in the short-term.

Markets care about the inflation data because it has a direct bearing on Federal Reserve monetary policy decisions and it is interest rates that are the raison d'être for most moves in exchange rates.

Changes in interest rates, or hints of them being in the cards, are only made in response to movements in inflation but impact currencies because of the push and pull influence they have on international capital flows and their allure for short-term speculators.

"The continued upward trend in core CPI inflation, which rose from 2.2% to 2.3% in June, keeps the Fed on track to raise interest rates twice more this year," says Andrew Hunter, an economist at Capital Economics. "Nonetheless, with the labour market exceptionally tight and activity expanding strongly, we think that core inflation has further to rise. The prospect of further tariffs on Chinese imports will only add to that upward pressure."

The US Dollar index was quoted 0.02% lower at 94.72 following the release, after whittling away an earlier 0.19% gain. The Pound-to-Dollar rate was 0.13% higher at 1.3233 after reversing a fractional loss while the Euro-to-Dollar rate converted a 0.17% loss into a smaller 0.01% decline that left it trading at 1.1674.

The Dollar has converted a 4% 2018 loss into a 2.8% profit during the two months since the middle of April, following a sustained rally that drew a line beneath the greenback and a prior 12-month period of heavy losses.

Most analysts now agree that superior levels of growth have bolstered the case for the Federal Reserve to keep raising its interest rate, at a time when the interest rate outlook elsewhere in the world is deteriorating, which has incentivised traders to sell other developed world currencies and buy Dollars.

"A few months ago, it was easy to say that December 2016 was a peak and that the USD was in a downtrend. Now the picture isn’t so easy to diagnose in that way. We could be in an incomplete USD uptrend, although it would be the longest in history if true," says Greg Anderson, global head of FX strategy at BMO Capital Markets. "With the US expansion more mature than the Rest Of World’s, maybe a slightly strong USD makes sense."

Thursday's data comes amid heightened international tensions over White House trade policies and as President Trump concludes a two-day North Atlantic Treaty Organization summit.

Trump criticised Germany at the summit for its decision to fund a new Russian gas pipeline in Europe and spent most of the two days lobbying for European countries to increase their defence spending, but the so called trade war between the US, China and, more recently, the EU has remained front and centre throughout the week.

The White House is pursuing restrictive legislation to govern Chinese investments into the United States and recently ordered a range of tariffs be levied against imports of more than $250 billion in imports of Chinese goods. 

Trump also placed tariffs on all imports of steel and aluminium from China, Canada, Mexico and the European Union in an effort to reduce the US trade deficit, which he has cited repeatedly as a sign of malpractice by other countries and evidence that protectionist action is needed by the White House.

The EU has since responded with its own levies on US motorcycles, jeans and whiskey, drawing threats of even more tariffs from the White House, this time targeting the mighty European automotive sector.

Fears are that a tit-for-tat tariff fight between the world's largest economies will quickly descend into an all out "trade war" and that this will dent economic growth in all countries it touches, which could stymy the Federal Reserve from raising its interest rate further while also denting the odds that other central banks will be able to raise their rates any time soon.

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