The latest data on US inflation produced a bombshell effect on the markets.
On Thursday, the greenback recorded one of the strongest one-day falls for the current year.
The EUR/USD pair registered an impressive growth, reaching the highest values since mid-August 2022.
Key Wall Street indicators ended Thursday's trading with explosive growth, demonstrating the most significant rise since 2020.
The rally of risky assets, led by US stocks and the euro, took place amid a large-scale dollar sell-off, as investors believed that the Federal Reserve was entering the final stage of its current interest rate hike cycle due to signs that inflation had finally peaked.
According to the US Department of Labor, in October, the basic consumer price index in the country increased by 0.3% on a monthly basis. This is half the September growth and below the expected 0.5%. The indicator rose by 6.3% year-on-year compared to the projected 6.6%.
In addition, the overall consumer price index rose at the lowest pace since January of this year – to 7.7% compared to the same month last year and against 8.2% in September.
Data released on Thursday also showed that key items such as rents rose less than expected, while the used car price index – the culprit of the initial pandemic-related surge in inflation - fell by 2.4%, showing the fourth consecutive monthly decline. Prices for air tickets, medical services and clothing also decreased.
Softer-than-expected inflation in the US has become a tailwind for the markets, according to strategists at B. Riley Financial.
"Each line of the report shows a consistent improvement. Inflation is clearly moving in the right direction, and this should weaken the Fed's hawkish attitude," they said.
"The markets welcomed the positive news, the yield of treasuries fell, the dollar weakened, and stock prices rose," UniCredit Bank economists said.
The S&P 500 index rose by 5.54% and ended Thursday's session at 3,956.31 points.
Meanwhile, the greenback fell against a basket of currencies by more than 2%, finishing around 107.80 points.
Amid the weakening of the dollar, the EUR/USD pair jumped by almost 200 points from the last closing levels near 1.0010.
"The dollar movement was quite sharp on Thursday. We really think that the results of the US consumer price index for October confirmed the possibility of a slowdown in the Fed's rate hike in December," Commonwealth Bank Australia analysts said.
The fall in USD was exacerbated by the decline in the yield of US Treasury bonds.
The indicator for 10-year securities fell below 4%, reaching the lowest level in a month, as traders revised their expectations about how much the Fed will raise rates at the next meeting and where rates may peak.
After the release of the US inflation report, the probability of an increase in the cost of borrowing in the United States in December by 50 basis points jumped from 52% to 85%.
Futures for the federal funds rate currently provide for a maximum interest rate in the range of 4.75%-5% in March next year – lower than the range of 5%+ observed before the release of October inflation figures in the United States.
"Inflation in the US is likely to continue to slow down in the coming months, which will significantly reduce the need for the Fed to continue aggressively raising rates. This confirms our opinion that the central bank will raise the rate by 50 bps in December," DNB Bank analysts said.
UniCredit strategists also believe that the Fed will begin to slow down the pace of rate hikes at the December meeting, raising rates by 50 bps, not 75 bps.
Indeed, the weak consumer inflation report for October justifies the Fed's decision in December to reduce the pace of rate hikes.
However, it is still difficult to agree that the futures market has lowered its expectations regarding the final Fed rate in 2023.
It is important for investors to understand that even if inflation decreases, it will remain significantly higher than the level acceptable to the Fed, and the central bank will probably not be inclined to rest on its laurels and just watch inflation after it missed the price increase last year.
"We are going from a state of "red-hot" to "boiling", this is not "cold" enough for the Fed," KPMG economists noted.
Betting on the Fed's less hawkish stance has been a risky strategy so far this year. The US stock market has repeatedly bounced off the low amid hopes for a so-called reversal in the Fed's policy, only to find itself again under pressure from high inflation and a sharp tightening of monetary policy.
"The market – as it has been several times this year – really wants to trade the Fed reversal. But we think that the market is slightly ahead of itself, based on one good inflation report," said Horizon Investments strategists.
"There were glimmers of optimism in the October release of the consumer price index, but this pattern needs to be repeated in the coming months for confidence to grow that inflation will slow down towards the Fed's target level," ANZ analysts said.
Although FOMC officials felt some relief from the latest inflation data, they were quick to say that the fight against rising prices is far from over.
"The latest data on the consumer price index was a welcome relief, but there is still a long way to go. While I believe it may soon be appropriate to slow down the pace of rate hikes so that we can better assess how financial and economic conditions are developing, I also believe that a slower pace of rate hikes should not be seen as an easier policy," Dallas Fed President Lorie Logan said.
Commenting on the October report on the consumer price index, the head of the Fed Bank of San Francisco Mary Daly noted that this is good news, but added that one month of data is not enough to declare victory.
"We must continue to adjust the policy until our work is fully done. Now is the time to reduce the rate of increase in the key rate. But there is a lot of uncertainty about what the maximum rate level will be. We need to make sure that inflation does not take root," she said.
Meanwhile, the head of the Fed Bank of Cleveland, Loretta Mester, believes that the Fed's monetary policy should become more stringent and remain restrictive for some time in order to direct inflation on a steady downward path to the US central bank's target of 2%.
The next report on the US consumer price index will be released on December 13, and the next day the Fed will announce its decision on monetary policy.
It is worth recalling that in July there was the same slowdown in the basic consumer price index. When this indicator rose by 0.3%, the markets were encouraged, but then faced two consecutive jumps in the base CPI by 0.6%.
In case of a return to strong inflation indicators, the Fed's increase in interest rates by 50 bps in December will be accompanied by forecasts of higher rates.
However, investors have not yet taken this scenario into account in quotes, and the so-called "relief rally" in the markets continues.
Key Wall Street indicators were trading in positive territory on Friday. In particular, the S&P was adding about 0.2%.
Investors' appetite for risk received an additional boost from news from Chinese health authorities that eased some of the country's strict restrictions on COVID-19, including shortening quarantine periods for close contacts with patients and incoming travelers.
"There have already been rumors about this, but the fact that they did it is a step in the right direction in terms of fine-tuning the COVID-19 zero-spread policy," Bank of Singapore analysts said.
Against this background, traders continued to invest in risky assets, and the dollar dropped by about 1.5%, updating multi-week lows near 106.50 points.
The prevailing risk appetite in the markets allows the euro to outpace its American counterpart.
On Friday, the EUR/USD pair maintained a bullish momentum and rose to peak levels over the past three months above 1.0300.
The reaction of the markets to the latest US inflation data shows that investors are quite desperate for good news and may be getting ahead of themselves.
Both core and overall inflation may be slowing, but U.S. inflation remains at levels not seen since the 1980s, so the Fed will continue to move forward, albeit at a slower pace, economists at Julius Baer believe.
"Inflation remains too high to allow the Fed to declare victory," they noted.
"The Fed will slow down the pace of rate hikes at its next meeting in December, raising the target rate range by 50 basis points, to 4.25-4.5% by the end of the year. This would make the current rate hike cycle, by a total of 525 basis points in just nine months, one of the steepest and largest in the Fed's history, creating significant obstacles to economic growth in 2023," analysts warn.
"One of the key conditions for a broader depreciation of the USD would be an acceleration of economic growth in the rest of the world. Thus, expectations of a significant slowdown in global economic growth in 2023 will correspond to the continued support of the dollar," Julius Baer reported.
"The market welcomed the slowdown in inflation in the US. But it may be a little dangerous because the bad news still exists and may come back to change the market's opinion, especially with regard to the Fed," Rabobank analysts said.
"Recently, there have been signs that investors are looking for profitable offers in risky assets. However, we do not see sufficient grounds to abandon our bullish forecast for the US dollar," they added.
"In addition to the prospects for higher rates, in our opinion, the greenback will continue to be supported by safe asset flows. This year, the increase in interest rates in the United States undermined the prospects for risky assets and helped attract investors to a safe dollar. At the same time, the strength of the USD restrains global trade and global growth, which again leads to demand for the US currency. Perhaps the dollar is approaching the late stages of its rally, but we think it's too early to expect it to change its course," Rabobank said.
Thursday's data on the consumer price index (CPI) in the United States dealt a serious blow to the greenback. Nevertheless, it is too early to talk about a steady downward trend of the US currency, ING economists believe.
"It is still too early to talk about the Fed's victory in the fight against inflation, and more evidence should come from the labor market, which remains exceptionally tense. The US central bank may not be very interested in moving to a more dovish position without collecting all possible data before the December meeting," they noted.
"Currently, there are still not enough alternatives to the dollar. The euro is benefiting from lower gas prices, but this is due to mild weather, and concerns about the energy crisis this and next winter are unlikely to ease in the next few months. Markets are also welcoming the easing of COVID-19 regulations in China, but the number of cases of infection with the virus in the country remains high. This means that the path to the complete abolition of restrictions in the country still looks long," ING reported.
"In addition, risky assets face downside factors that go beyond the history with the Fed: from the likely reduction in corporate profits to problems in the cryptocurrency market. Perhaps the peak of the dollar has already passed, but the downward trend in USD has not yet begun. We remain moderately bullish on the dollar until the end of the year," the bank said.
The EUR/USD pair has grown sharply and may grow even more before the beginning of December, but in three months it will fall to 0.9700, according to Nordea.
"In the short term, before the beginning of December, the dollar may weaken even more, and the EUR/USD pair will rise to 1.0500. The greenback usually weakens during an increase in risk appetite, which we can observe in the coming weeks. Although the main currency pair may grow before the beginning of December, we still expect it to decline to 0.9700 in three months," the bank's strategists said.
"The Fed's fight against inflation is not over yet, given high wage growth and labor market tensions. Next year, the central bank may need to raise rates more than we and the markets currently expect. The percentage differentials between the euro and the dollar are likely to move in favor of a decline in EUR/USD. Moreover, the Fed's rate hike also means that in the next three months a risk-off may re-enter the arena, which will lead to a depreciation of the euro against the dollar," they added.
So far, the EUR/USD bulls are heading towards the six-month resistance area, which is around 1.0355-1.0370. In case of a breakout of this area, bulls can head to the 200-day moving average at 1.0440.
Alternatively, a close below the key support at 1.0200 could trigger a pullback of EUR/USD and retest the 100-day moving average at 1.0030. Next, the 1.0000 and 0.9850 levels will come into play. If bears break the last mark, they may aim for October lows near 0.9630.
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