Dollar on Watch: Traders Anticipate Slide After Inflation Data
Currency traders are bracing for a potential drop in the value of the US dollar following the release of Wednesday’s key inflation report. This anticipation stems from a build-up of bearish bets placed by option traders on the world’s reserve currency. In the lead-up to the release of the April consumer price index (CPI), a normally positive index reflecting risk sentiment (one-week risk reversals) dipped below par for the first time in two months on Tuesday.
This shift in sentiment reflects hope that inflation may be easing, potentially prompting the Federal Reserve to adopt a more dovish monetary policy stance. Jerome Powell, Chair of the Federal Reserve, reiterated on Tuesday that an interest rate hike is unlikely to be the central bank’s next move. If inflation shows signs of cooling, it could reinforce this viewpoint and refocus traders’ attention on the possibility of monetary easing later this year. This, in turn, could exert downward pressure on the value of the dollar.
“A lower-than-expected inflation print could ignite hopes that the Fed will consider a rate cut this summer, which would reduce the dollar’s yield advantage,” explained Kyle Chapman, FX markets analyst at Ballinger & Co. However, he cautioned, “the Fed will likely require several months of consistently positive data before gaining confidence to ease policy.”
Dollar Bullishness Wanes as Inflation Decision Day Approaches
Economists polled by Bloomberg predict that the data will show a slowdown in the rate of US consumer price increases, with inflation dropping to 3.4% in April compared to 3.5% in March. An inflation reading that meets or falls below forecasts would likely solidify expectations for the Fed to implement two quarter-point interest rate cuts throughout the remainder of the year. The Bloomberg Dollar Spot Index dipped on Tuesday, coinciding with Powell’s call for patience regarding inflation.
Backing up this shift in market sentiment, data from the Commodity Futures Trading Commission (CFTC) for the week ending May 7th reveals that traders are scaling back on large, bullish dollar bets. Non-commercial speculators, which encompass hedge funds and asset managers, currently hold only around $24 billion in trades tied to the expectation of a rising dollar. This represents the smallest amount since early April.
Historically, cooler-than-expected inflation data has correlated with a decline in the dollar’s value. Over the past year, there have been three instances where inflation readings came in below forecasts. In each of those cases, the dollar ended the trading week significantly lower.
Traders Are Ready for Dollar to Drop After US Inflation Data
Euro Poised for Potential Gains as Dollar Sentiment Sours
While traders are turning away from the dollar compared to other major currencies, the euro appears to be enjoying a particularly positive outlook. The relative premium for call options on the euro (which represent a bet on its appreciation over the next week) has climbed to its highest level since February. This indicates a growing expectation that the euro will strengthen against the dollar.
According to Bank of America Corp. strategists Howard Du and Vadim Iaralov, European investors have “fully unwound long dollar positions held over the past month.” This shift in positioning by European investors has fueled Bank of America’s bullish view on the euro relative to the dollar leading into the US inflation report release.
The Bottom Line
The upcoming US inflation report on Wednesday carries significant weight for the near-term trajectory of the US dollar. If the data reflects a slowdown in inflation, as many anticipate, it could pave the way for the Federal Reserve to adopt a more dovish monetary policy stance, potentially leading to interest rate cuts and a depreciation of the dollar. This, in turn, could benefit other major currencies such as the euro. The coming days will be crucial as markets closely watch the inflation data and the subsequent response from the Federal Reserve.
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