Will Realized Inflation Fears Drive U.S. Dollar To Fresh Highs?

The U.S. dollar traded lower against all of the major currencies. The lack of U.S. economic releases meant that the greenback took its cue from yields. After hitting a high of 1.6%, 10-year Treasury yields pulled back as traders wait for the stimulus bill passage and Wednesday‘s inflation report. The House plans to vote on the $1.9-trillion relief package tomorrow and, while there’s always risk that investors will sell the news, the economic impact of $1,400 stimulus cheques will be too significant to overlook for long. The $600 December stimulus payment drove retail sales up 5.3% in January, far higher than economists anticipated. The $1,400 stimulus cheque is two times greater and should provide an even bigger boost to the economy in the second quarter.

The only problem is that the consumer price index is also scheduled for release, and this report is widely expected to reinforce everyone‘s concerns about inflation. Between January and March, 10-year Treasury yields rose from 0.95% to a high 1.6%. This alarmingly fast move was driven entirely by inflation expectations. The economy is improving, interest rates are low and many investors believe that the rise in commodity prices will translate into broader price increases. This could, in turn, force central banks to review their policies and reduce stimulus earlier than expected. The Federal Reserve says that won’t be the case, but based on the rise in yields and the U.S. dollar, investors think otherwise.

The stock market provided an important clue on what will matter more to investors on Wednesday. The Dow Jones Industrial Average was up more than 200 points intraday but gave back nearly all of its gains by the end of the New York session. This decline reflects concerns about stronger CPI, its potential to drive yields higher and equities lower. Stocks are vulnerable to a correction, which could drive the U.S. dollar.

The Canadian dollar will also be in focus with the Bank of Canada‘s monetary policyannouncement. The overall strength of the loonie tells us that investors are bracing for optimism. While other major currencies sold off last week and into Monday, USD/CADtraded in a very tight range. According to the latest economic reports, Canada’s economy is improving. Manufacturing activity accelerated, GDP growth beat expectations, the trade surplus increased and more builders are applying for permits. So while vaccine rollout has been slow and restrictions remain for many provinces, the outlook brightened. Combined with the prospect of a stronger employment report at the end of the week, the BoC will most likely maintain its optimism. The only problem is the strong currency. The Canadian dollar is hovering near a three-year high, and the central bank may not want to take steps to drive it even higher.

Meanwhile, mixed Eurozone data allowed EUR/USD to bounce off the 200-day SMA. Germanys trade surplus declined, but exports grew at a faster pace. Fourth quarter Eurozone GDP growth was revised lower, but Q3 numbers were revised higher. The European Central Bank meets on Thursday and, unlike the BoC, the ECB has more reasons to be dovish.

The best performing currencies were the Australian and New Zealand dollars, which is no surprise as both countries continue to recover. Still, Australian business confidence improved, while New Zealand business confidence deteriorated. Weve been seeing more improvements in Australia data than New Zealand, which could pave the way for a stronger AUD/NZD cross.