Market Commentary: US inflation cools | What’s behind the recent USD strength

12 August 2022
Stephanie Leung
CIO Office

Watch Freddy Lim, co-founder and CIO and Stephanie Leung, Co-CIO, discuss the latest global events and their potential impact on the markets and on our investment portfolios.

In this episode:

  • US inflation comes in lower than forecast [0:15]
  • Could the US be heading into a recession? [3:00]
  • What’s behind the recent US Dollar strength? [5:35]


Stephanie | 00:01

Hi everyone! Welcome to another episode of Market Commentary from StashAway. Together, we have Freddy Lim and myself, talking about the economy and what's happening in markets. Freddy, it's been quite an eventful week, particularly for the US - there's a bunch of data that came out, namely the CPI, which seems to be getting a lot of attention. Can you walk us through what's happening with the inflation front in the US?

Freddy | 00:23

Well, if you take a step back and also to what we said throughout the year - prior to this release, which is a good news that we will go into - we've been mentioning that the Fed focuses a lot on core inflation, which is the inflation ex-energy and fresh food. And those numbers have been all the way elevated up until 3 months ago, they started to soften and stabilise and stopped rising. Unfortunately, energy prices, gas prices, and all the disruptions persisted and the headline CPI continued to go up. Now, there's good news last night because the latest release for the headline CPI actually showed the first decent decrease or moderation in price pressure. So on a year-on-year basis, we went from 9.2% in the months prior to 8.5% year-on-year. That's a pretty substantial drop for the month and is likely going to continue to drop because of the base effect. As long as energy prices stay here, the base effect will start seeing those headline numbers come down and converge a bit more towards the core inflation metrics. So overall, the markets took relief to it. And additionally, after the release of the data, some more Fed members on the FOMC committee also started expressing that they're open to slowing the amount of hikes they have. So these are all very good news for risky assets, growth-oriented assets, and also to the general government bonds itself.

Stephanie | 02:03

Yeah, I guess right now, the next Fed meeting will be in September. So the Fed gets a summer break. The market is expecting the Fed to actually hike around 60 basis points. And the terminal rate, which is kind of where the ultimate interest rate would peak, is expected to be around 3.6% somewhere in the first quarter or second quarter next year. So I guess from now till then, it seems like the rate hike cycle will continue, but there is some hope that the Fed will start to moderate the rate hikes starting next year. Of course everything goes back to inflation and what happens to oil prices or more stickier parts of inflation. So for example, if we look at the rent CPI, which is a big part of the core CPI, it's still going up, but it went up less than last month. So it's a pretty good print in terms of CPI.

Freddy | 03:00

Well Stephanie, I do have a question for you. Because you also in the past mentioned that there's some probability of a rate cut further out being priced into the markets in particular for the end of 2024, we see the Fed funds markets starting to price in some amount of rate cuts. Is that good news or bad news or is that indicating some sort of recession probability afterward or what's your view on that?

Stephanie | 03:31

Yeah. I guess we got a lot of questions about whether the US is going to enter recession. And that is basically because inflation, although it has come down, is still quite high. So an 8% headline is still way, way above the Fed's stated 2% target. Although, as Freddy said, some Fed members have expressed that if they can get the inflation rate to around 4% or thereabouts by the end of the year, they'll be quite happy. So what that means is that the Fed interest rate will actually stay quite high for quite some time, especially versus the neutral rate, which is around 2% to 3%. So that kind of risks pushing the economy into recession, we've actually seen a significant slowdown in some of the, I guess, small cyclical parts of the US economy, if you look at ISM and particularly new orders, which tends to be quite leading, it is kind of bordering on contraction territory. However, if you look at the labour market in the US, it's still very strong. So different data is sending us different signals about the strength of the economy. But typically, labour market data tends to be a bit lagging and that's why the market has been concerned about recession. If you look at Google search trends, the word "recession" has been searched more even compared to during COVID-19 times. So the reason why the market is already expecting the Fed to cut rates as early as next year is because they expect the Fed's action to be able to slow the demand side of the economy, hence bringing down prices. Because, for example, if people lose their jobs or they don't get paid as much, they can't pay that much for goods and services. And that means that prices of these goods and services should start to come down. And really, the question now is how aggressive will the Fed be and also how deep if we get a recession, how deep is the recession?

Freddy | 05:35

So, Stephanie, we've seen the median forecast of recession like in 12 months time, that kind of metric, starting to show the probability of recession starting to rise. And it's now if I'm not wrong, it's slightly above 30% and is heading towards 35%. So that's probably in line with what you just said. Now, we, on the one hand, have this higher probability of recession and on the other hand, we are still fighting inflation, and that's slowing. What does all this mean for the US dollars? Do you have something to share here?

Stephanie | 06:11

Yeah. I mean, the US Dollar has strengthened a lot versus a broad basket of currencies, not just emerging markets, but also more developed markets, including the Euro and the Japanese Yen. And that was because of the Fed's very aggressive interest rate hikes, much more aggressive than any other central banks in the world. And the reason? Interest rate hikes lead to US Dollar strength because think about kind of if you have cash and you get more interest on the US Dollar, you would convert that cash from your home currency maybe or other currencies into the US Dollar, and that has strengthened the US Dollar quite significantly over the past 12 months. Apart from that, of course, the US Dollar is still the world's reserve currency. So in times of uncertainty, the US Dollar acts as a safe haven. So we've seen a very, very significant strengthening of the US Dollar. The question is now are we going to see even more strengthening or is the US Dollar coming to a pause? Given that the concerns about the US recession, especially as Freddy said, is rising quite significantly. And I think that depends on number one, the economic data that comes out because if the US does go into a recession, the US Dollar can strengthen against other riskier currencies, particularly the emerging markets. However, some of the most safe haven currencies actually may start to outperform again because, for example, the Japanese Yen, the reason for the US Dollar to appreciate against the Japanese Yen is because of the interest rate differential, i.e. US interest rates are higher than the Japanese Yen interest rate. But if the Fed starts to cut interest rates, then the differential kind of shrinks and the US Dollar would probably weaken against the Japanese Yen. So at the end of the day, it's got to be more nuanced in my view going forward, particularly given that the market is pricing in a kind of shallower path of US policy rates going forward.

Freddy | 08:14 

So given its complex dynamics, if I summarised it correctly, you have on one hand, if you continue to fight inflation with rate hikes and the US Dollar leads the way, that's US Dollar-positive. On the other hand, you have a higher probability of recession that may put the US Dollar, Yen, Swiss Franc, and all the safe haven currencies in a stronger light again. So, that is sort of the situation. So inflation slowing is bad for the US Dollar, the probability of recession going up is good for the US Dollar. So there's a tussle of the two factors that we are seeing here if I'm correct.

Stephanie | 08:54

Yeah, I think so. And I guess for the US Dollar to truly reverse, i.e. weaken against most currencies, we need to see better data coming out not just from the US but globally, for example from China, Europe, etc.

Freddy | 09:10

So if I may make a base case here, given that the market has priced in a certain amount of rate cut, it's not severe, it's probably in line with a moderate recession. And the Fed has expressed that in the past, a moderate recession is fine if you can get inflation down. So let's say that's a base case, inflation is heading down, we've got a base case of a moderate recession and the market has already priced in a lot of this. That means that the US Dollar could be going nowhere - just where it is now, because this is what the market is pricing.

Stephanie | 09:44

It could be range bound for a while, I guess, especially given it's very overbought now, given how much it's risen.

Freddy | 09:53

Yeah. So it's a tough question. I thank all our clients and listeners of this channel for asking this question. As you can tell, it's really complex. But hopefully, at least we share with you the components of what drives the US Dollar and how we think about it. We will continue to monitor it and perhaps as our views change, update you in this channel again. So with that, thanks a lot Stephanie. It's been great to see you again.

Stephanie | 10:24 

Thanks a lot, Freddy. And for everyone who is interested in the FX topic, our next CIO Insights is going to have a deep dive into FX as well. So stay tuned.

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