USD: More evidence of slowing US inflation will weaken the USD
The USD has continued to correct modestly lower over the past week resulting in the dollar index falling back towards the 100.00-level. The USD has weakened against all other G10 currencies apart from the JPY which continues to underperform. Comments from Japanese officials including today from Prime Minister Takaichi signalling a potential policy shift to encourage domestic investors including the GPIF (click here) to further increase investment in domestic assets have so far failed to provide significant support for the JPY. The impact has been most evident so far in the JGB market where yields have fallen since late last week. The 10-year and 30-year yields are currently trading around 20bps and 25bps below recent highs.
At the same time, media reports suggest that the government is seeking to ease concerns that it could constrain the BoJ’s ability to tighten monetary policy. Reuters has reported that the government has revised its economic policy blueprint to make it clear that decisions regarding specific monetary policy tools should remain the sole responsibility of the BoJ. This should help alleviate investor concerns that the BoJ could fall further behind the curve in responding to higher inflation. However, Prime Minister Takaichi will still have the authority to appoint two new Policy Board members next year when the terms of Hajime Takata and Naoki Tamura expire on 23rd July 2027. Both are generally regarded as hawkish by BoJ standards. In contrast, Prime Minister Takaichi’s two recent appointments to the Policy Board, Toichiro Asada and Ayano Sato, are viewed as relatively dovish. While these appointments are unlikely to influence BoJ policy materially this year, next year’s appointments could make it more difficult for the BoJ to continue normalising policy from the second half of 2027 onwards. Against that backdrop, it is even more important for the BoJ to continue raising rates over the next 12 months in order to restore confidence in the JPY.
In contrast to the continued underperformance of the JPY, the two best-performing G10 currencies this week have been the NOK and NZD. The NOK has rebounded alongside renewed military tensions in the Middle East, which have pushed Brent crude prices back above USD85/bbl. As a result, oil prices are now back over 20% higher than their pre-conflict levels. According to Bloomberg, tanker traffic through the Strait of Hormuz has slowed sharply once again, and there is still no clear indication of when the latest round of military strikes will come to an end. Under normal circumstances, we would have expected the USD to strengthen in response to higher energy prices. However, the release of significantly softer US inflation data this week has had a more powerful impact, dampening expectations for further Fed rate hikes in the near term. It was widely anticipated that headline inflation would ease, given that average gasoline prices fell by around 10% in June. The main surprise, however, was the broader-based nature of the disinflationary trend, with core inflation unchanged on the month. It was the largest downside surprise in core inflation since April of last year. Fed Chair Kevin Warsh has welcomed the improvement in inflation but stopped short of declaring victory, instead reiterating the Fed’s commitment to restoring price stability. While the latest data do not completely rule out a Fed hike as soon as this month, the bar for further tightening has risen. The softer inflation backdrop gives the Fed more time to assess inflation risks over the summer before deciding whether additional tightening is warranted in the autumn. Admittedly, it will also become increasingly difficult politically to raise rates as the November mid-term elections draw closer.
