US Dollar Reacts to Inflation Data While Geopolitical Events Loom

The report on consumer prices in the United States triggered a U-turn in the dollar yesterday, as the widely expected slowdown in inflation did not materialize. Despite the relatively unremarkable overall picture – overall inflation remained at 3.7%, and core inflation slowed from 4.3% to 4.1% – the markets were deeply concerned about the details of the components that make up the CPI. The corresponding table is presented below:The components of the CPI that most fully characterize its trend are highlighted in red. These are services in general and their sub-component, housing-related services. Inflation in these components is the least volatile and shows inertia; if there is an increase, it is likely to continue in the next month. In economics, there is a concept of sticky prices, and that's precisely what these components are. Moreover, in the services sector, labor has a higher share than capital, so the weight of wages in total costs is high. Therefore, when inflation in these CPI components rises, one can expect, with a high degree of probability, an adjustment in wages in the coming months. Wage growth increases demand, including in the services sector, and so on in a cycle. This is why the Federal Reserve pays special attention to inflation in the services sector, as it generates secondary, tertiary, and so on rounds of inflation.It can be seen from the table that services’ inflation accelerated from 0.4% to 0.6% MoM, and shelter inflation – from 0.3% to 0.6% MoM. Consequently, markets had to reassess their forecasts for an inflation slowdown. This led to a repricing of the Fed rate path as well. Bond yields rose by almost 20 basis points after yesterday's report – almost a full standard interest rate hike by the Federal Reserve. Subsequently, of course, there was a pullback, but in my view, it was driven by news indicating an increase in geopolitical risks, as gold rose disproportionately from $1,870 to $1,910 per troy ounce.This morning, the government of Israel warned UN staff to evacuate from Gaza and informed residents of the northern part of the Gaza Strip to move to the south within the next 24 hours, increasing the likelihood of an immediate large-scale ground operation. Yesterday, Syrian media reported that Israeli airstrikes targeted airports in Damascus and Aleppo. Meanwhile, according to reports, the United States has increased diplomatic efforts to prevent the spread of the conflict to other fronts in the Middle East. The situation is clearly too unstable to predict its impact on the market, but it can be considered fair to say that the start of an Israeli ground operation in Gaza could contribute to a more defensive trade and benefit currencies such as the dollar, Swiss franc, and yen, as some investors consider a higher risk of the conflict spreading to other fronts. Political and geopolitical events are beginning to take center stage in the currency market as the weekend approaches. In the American calendar today, surveys from the University of Michigan are included, and as usual, the main focus will be on inflation expectations, which are expected to remain stable. Patrick Harker is the only scheduled speaker from the Federal Reserve.