FX.co ★ Yen takes advantage of US dollar's slump

Yesterday's cooler than expected US inflation data undermined the US dollar. USD tumbled against most other major currencies, suffering the biggest losses against the Japanese yen.

The US dollar's Black Wednesday

Yesterday, the US currency had its worst intraday performance in months. The US dollar index or DXY fell by more than 1.5%, as the yield of 10-year US Treasury bonds plunged to 2.67%.

US Treasury bonds and USD came under pressure from US CPI data for July, which was well below expectations of economists.

Falling gasoline prices pushed inflation down to 8.5% in July from 9.1% recorded in June. Market players expected inflation to slide down to 8.7%.

Core CPI, on the other hand, remained unchanged at 5.9%. Economists expected the index to rise to 6.1%.

Declining prices of airline fares, communication equipment, apparel, and used cars last month prevented the core CPI from moving upwards.

Lower inflation in July suggests that inflationary pressure in the US could have peaked and could begin to decrease steadily in the future.

This is a very negative factor for US Treasury bond yields and the US dollar. Low inflation could make the Fed slow down its monetary tightening cycle.

Since the beginning of the year, the US central bank increased interest rates 4 times, including two 75 bps moves in June and July, as part of its campaign to bring down inflation.

The Fed's hawkish tactics pushed up the US dollar significantly this year. However, if the regulator softens its stance, USD could quickly reverse downwards and tumble.

Does anyone need dollars?

While many analysts have predicted that USD would decline if inflation decreased in July, few could predict the US dollar's downward slide would be that extreme.

During its massive sell-off on Wednesday, USD fell against all major currencies.

The US dollar lost 0.84% against the euro in its biggest intraday decline since mid-June.

However, USD suffered the biggest losses against the Japanese yen. JPY increased by 1.6% against USD on Thursday night.

The skyrocketing jump of JPY was not unexpected for market players. It was caused by the sharp decline of US Treasury bond yields.

In 2022, the yen has sunk against the dollar due to the monetary policy divergence between Japan and the US, which created a large gap between yields of US and Japanese sovereign bonds.

Now, when the yield of US bonds has slumped, reducing the gap, the yen found a strong impetus for growth.

Yesterday, USD/JPY dropped to 132.00, falling by more than 200 points in its largest plunge in more than two weeks.

USD will prove itself

The dollar's further price dynamics would depend on the actions of the US central bank.

Over the past several months, Fed policymakers have repeatedly stated that they would stick to their monetary policy tightening plans until they see clear signs that inflation is under control.

Analysts at Commerzbank believe that inflation in the US has peaked, but it is rather early to say that the problem will be resolved soon.

"The collapse in the price of gasoline played a decisive role. The further decline in the inflation rate is therefore likely to be slow", the analysts said.

Claire Fan, economist at RBC Capital Markets, said inflation will not go down soon. As a result, the Fed would not likely ease its policy in September.

"Current readings are too high, and pressures too broad to deter the Fed from acting more aggressively in the near-term. By our count, as much as 87% of consumer basket (outside of shelter) was seeing above-target rate of inflation in July. That will keep the Fed on track to deliver more rate hikes this year, with our forecast assuming another 50 bps increase in the next meeting in September," Fan noted.

Currently, the markets are pricing in a 57.5% probability of a 50 bps hike at the next meeting of the Federal Reserve. A 75 bps move is also possible.

The Fed is yet to receive a lot of statistical information that would influence its decision in September, making yesterday's panic in the FX market rather premature.

The US dollar could likely rally in the upcoming days as panic in the market dies down. USD would likely have upside potential while the Fed policy course remains unclear, many analysts say.