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Analysts at Nordea explained that the dollar has been on the backfoot recently, with disappointingly low core inflation one driver of a correction in the dollar index. EM currencies have also been faring better.  

Key Quotes:

“While weaker-than-expected core inflation can reasonably cast doubt on the Fed’s rate path (& dent the dollar), we think it is too early for that. While year-to-date dollar strength and strong productivity suggests further downside risks to core inflation also over the next six months, but Trump’s tariffs and higher wage growth should offset some of this.

FOMC commentary also suggests it won’t care mild inflation disappointments. Arch-dove Brainard has turned hawkish, saying the US is at risk of accelerating inflation or financial imbalances. The Fed’s assessment is “that financial vulnerabilities are building” and “sizable fiscal stimulus in the pipeline is likely to continue to bolster the short-run neutral rate over the next two years”. Keeping this in mind, it looks extremely unlikely the Fed will stop hiking anytime soon.

The Fed’s estimate of the neutral rate has likely been capping the upside in both Fed Funds pricing and the 10y yield. But if the shorter-run neutral rate is now rising to levels above the long-term estimate, we have a dynamic which implies upside risks to both the end-point as priced in the FF curve and to the 10y yield. This is dollar-positive as well as EM-negative. That the 10y yield has revisited 3% consequently seems fair, and a revisit of 3.10%-3.12% may well be on the cards.

The consensus explanation of some of the recent dollar weakness is easing trade tensions and low inflation reigniting risk appetite – but we think another, under-appreciated factor, has also been at play”¦

The US Treasury’s cash balance at the Fed has recently dropped from ~350bn to below 300bn, this has consequently increased the supply of dollars in the banking system by 50bn. A guy such as Eddie Meduza would conclude that, if there are more dollars, it ought to be cheaper. And so it has become. The Fed’s “unprinting” does however continue apace with the next “SOMA day” on September 30. The US Treasury is telling us it will have a quarter-end cash balance of 350bn and a year-end balance of 390bn, indicating the Treasury will “unprint” a 100bn by itself. Taken together, the market will still cope with a dwindling supply of dollars heading into 2019.

We would accordingly seek to fade the recent relief in the EM space, insofar it has been driven by a greater supply of dollars or by expectations that a softer core inflation number will impact the Fed. Nope! The Pope of Nope has spoken.”

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