Market Adjustments and Inflation Slowdown: Implications for the Dollar

Last week, there was a significant adjustment in financial markets to the new reality, where sticky high inflation in the US may not be an issue anymore. This was primarily driven by the US inflation report, which revealed that core inflation, the most accurate indicator of consumer demand, slowed by 0.5% to 4.8% in June:In less than two weeks, the dollar depreciated by approximately 3.5% against its major peers, and Treasury yields dropped by 25-30 basis points. Essentially, this means that the market is no longer expecting two rate hikes by the Federal Reserve (Fed) this year, and at best, it anticipates only one hike, after which the tightening cycle should come to an end. It is worth noting that the head of the central bank, Powell, previously stated that none of the FOMC members expect a rate cut this year.Last week, the focus on the Consumer Price Index (CPI) was not the end of the story. Additional pricing data and survey indicators, such as the Producer Price Index and the University of Michigan Consumer Sentiment Index, also surprised on the positive side on Thursday and Friday. The former indicator, often serving as a leading indicator for consumer inflation (changes in production prices are transmitted to end prices through the cost channel), increased by only 0.1% in a month, falling short of the forecast of 0.2%. The monthly growth rates have been slowing down for several consecutive months. Thus, the groundwork continues to be laid for expectations that core inflation will reach a new low for the year in August. The U. of Michigan Consumer Sentiment Index rose from 64.4 to 72.6 points, beating consensus estimate of 65 points. The combination of slowing inflation and strong consumer demand characteristics allows market participants to accept higher levels of risk in search of yield. Consequently, the S&P 500 index reached its highest level this year, breaking above the 4500 level and approaching a critical resistance level, the upper boundary of the trend corridor:Weak GDP data from China increased the chances of fiscal or monetary stimulus from Chinese authorities. However, this momentarily exerted pressure on Asian equity markets, subsequently limited risk appetite in European markets as well. Data released on Monday showed that China's GDP grew by 6.2% in the second quarter compared to the previous year. Although industrial production and fixed asset investment in June exceeded expectations, the market's focus was on GDP data. This can be inferred from the updated growth forecasts for China by Barclays and Société Générale: the former lowered its forecast for China's economic growth in 2023 from 5.4% to 4.9%, while the latter lowered it from 5.5% to 5.0%. Today, the yuan weakened by 0.4% against the dollar, European markets adopted defensive positions, and the dollar is attempting to find support in order to pare deep declines from the last week. Similarly, to the S&P 500, a tactical short position on EURUSD with a short-term target in the 1.11-1.1150 range appears quite appealing within the framework of an intermediate correction following a sharp rally amidst a dull news backdrop this week. In my opinion, the pullback in the pair is significantly facilitated by the fact that the price reached the upper boundary of the trend corridor last Friday, deviating considerably from its moving averages:Considering that the long-term resistance trendline (highlighted in orange) is dangerously close for sellers, which medium-term buyers are likely to test for strength, shorting the pair with a target of more than 150 points may not be optimal. The majority of buyers will still seek opportunities to buy euros, hoping that the price will reverse precisely at the long-term resistance trendline, which will be located around the 1.15 level.