Tuesday is shaping up to be an intense day for the currency market. Just a day before the Federal Reserve announces its decision on interest rates, the most important economic indicator is set to be released. The fate of the US dollar hangs in the balance, as the US inflation data will have a decisive impact on the central bank's decision and the future trajectory of the greenback. Let us take a look at the potential scenarios for today's USD dynamics and identify the most likely outcome.
US dollar holds its breath
The US currency kicked off the day with declines across the board, but it remains trapped within a tight price range of 103.40-103.60.
The current sluggishness of the greenback can be attributed to cautious investor sentiment ahead of the crucial US consumer price growth data for May.
The timing of the data release coincides with the start of the Federal Reserve's two-day monetary policy meeting.
At present, futures traders are pricing in an 80% probability of the central bank announcing a pause in the ongoing tightening cycle tomorrow.
Market experts believe that the fresh inflation data could either reinforce prevailing market expectations or completely change the outlook.
Regardless of the outcome, the US dollar is poised to react strongly to the data release, potentially breaking out of its consolidation phase.
Today, USD volatility could skyrocket, but the direction of the move is uncertain. Analyst Yohay Elam has outlined three possible short-term scenarios for the US dollar based on the core inflation component, identifying the most probable one.
1. USD stalls
If the market observes a substantial easing of inflationary pressures in May, the likelihood of a rate hike this month would plummet close to zero. Such a scenario would significantly undermine the prospects for tightening in July.
What constitutes a substantial easing? According to Yohay Elam, an increase in the core Consumer Price Index (CPI) by 0.3% (or less) on a monthly basis would indicate a sustainable disinflationary trend, triggering a sharp decline in the dollar.
However, considering the recent signs of weakness in the US economy, such as the recent surge in unemployment claims, the expert believes there is an average probability of a 0.3% rise in core inflation. A lower reading appears to be highly unlikely.
2. USD skyrockets
A core CPI increase of 0.5% month-over-month equals a 6% surge year-on-year. This development would certainly not sit well with the Federal Reserve, which seeks to maintain inflation around the 2% level.
Sustained price growth is expected to prompt US policymakers to adopt a more aggressive stance, forcing traders to revise their forecasts to a more hawkish outlook at the eleventh hour. Consequently, the dollar would soar across the board.
Yohay Elam considers a 0.5% rise in the core CPI a possible but unlikely scenario, given that price pressures have recently begun to noticeably weaken across various sectors of the US economy.
3. USD declines moderately
If the core Consumer Price Index aligns with expectations and increases by 0.4% MoM, it would suggest persistent inflationary pressures, given that CPI also grew by 0.4% in April.
However, it would not be enough to persuade the Federal Reserve to signal further tightening in the near future. Instead, the central bank would likely opt for a pause in June and await additional data to shape its future course.
While trader confidence in a June pause would undoubtedly weigh down on the dollar, the extent of its decline would be relatively limited, as hopes for continued tightening in July remain intact.
Yohay Elam states that a 0.4% increase in core CPI is the most likely scenario, considering that economists' recent forecasts have been accurate in 4 out of 5 cases.
Additional factors to consider
In addition to the core CPI, traders will closely monitor the trajectory of overall inflation in the US. In this regard, the year-on-year figure carries greater significance.
Current economists' forecasts for annual CPI growth range from 4.8% to 3.9%. However, data from analytical aggregator Truflation suggests that the actual figure may lie considerably below this range.
Oliver Rust, Head of Product at Truflation, stated that the consumer price index was currently much closer to the 2% target, as indicated by the US government. According to Truflation's latest estimates, the real CPI was approximately 2.75% as of June 12, 2023.
If analysts' predictions prove accurate and inflation sharply declines year-on-year in May, the Federal Reserve is likely to hit the brakes and seriously consider the possibility of ending the rate hike cycle. Such a scenario spells trouble for the US dollar, potentially paving the way for a protracted bearish USD trend.
