Currency markets reacted swiftly to the softer inflation data. Traders now see only a 35% chance of a rate increase next month, down sharply from 55% a week ago. The cooling Producer Price Index reinforces expectations that the central bank will pause its tightening cycle, weighing on the greenback despite broader global economic uncertainties. Fed funds futures pricing reflects this rapid shift in sentiment.
Inflation Data Sinks Fed Rate Hike Bets
The Producer Price Index for final demand remained unchanged in July, missing economist forecasts of a 0.2% rebound. This followed a revised 0.1% drop in June. The back-to-back soft readings suggest that wholesale price pressures are finally easing after years of stubborn inflation. This directly impacts the personal consumption expenditures data due later this month.
Wednesday’s consumer price inflation report also showed that US consumer prices barely increased last month. Together, these reports provide the Federal Reserve with cover to maintain the current policy rate. Noel Dixon, senior macro strategist at State Street, noted that components feeding into the upcoming personal consumption expenditures report look promising.
“My takeaway from that number and yesterday’s number is that it helps to make the case for the Fed staying on hold in September,” Dixon said. The PCE report is the Federal Reserve’s preferred inflation gauge, and a soft reading could cement a dovish pivot.
Currency Markets React to Shifting Yields
The dollar index, tracking the US dollar against a basket of major currencies, rose 0.02% to 99.96. It had earlier slipped to 99.80 immediately following the PPI release. The index’s stability masks underlying volatility as traders adjust their interest rate expectations across major economies.
The euro gained 0.03% to $1.1528, benefiting from the shifting rate outlook. Meanwhile, the Japanese yen weakened 0.04% to 159.48 per dollar. The yen has given back some gains from last month’s historic joint intervention by the US and Japan. Investors remain skeptical of a sustained yen recovery without policy action.
“I don’t think it’s scared away investors from continuing to fade the yen unless we get the BOJ to deliver in September, and have an increase in hawkish guidance,” Dixon added. The Bank of Japan’s upcoming policy meeting is now a critical event for currency markets.
The pound weakened 0.08% to $1.3481, even as the UK economy unexpectedly grew in June. That growth was fueled by a dip in energy prices, the start of the men’s soccer World Cup, and unusually hot weather. The Norwegian crown also fell after Norges Bank held interest rates unchanged at 4.25% while flagging softer inflation. Against the crown, the US dollar strengthened 0.24% to 9.51.
Oil Supply Risks and Stable Labor Data
Geopolitical tensions added complexity to the inflation outlook. Oil prices pared early losses of over 3% to finish down less than 1%. Reports that Yemen’s Houthis targeted a Saudi Aramco refinery with drones renewed fears of supply disruptions in an already tight global market.
These supply concerns are compounded by ongoing Iran-related disruptions in the Strait of Hormuz. Rising energy costs could eventually feed back into consumer inflation, potentially forcing the Federal Reserve to reconsider its pause. Traders are weighing these supply risks against the current cooling price data.
Labor market data offered a counterweight to recession fears. Initial jobless claims rose moderately last week, indicating that employment conditions remain stable despite July’s surprise job losses. A resilient labor market supports consumer spending, which could keep the economy afloat even as rate hike bets fade.
What Happens Next
Investors will closely watch Friday’s retail sales data to gauge consumer spending strength. If spending slows alongside inflation, the Federal Reserve will likely confirm a prolonged pause. This would cap any upside for the US dollar in the near term. However, rising energy costs from Middle East tensions could revive price pressures and complicate the central bank’s path.
Currency markets will remain sensitive to these crosscurrents. The US dollar is vulnerable to further downside if rate hike expectations continue to evaporate. Conversely, any surprise strength in retail sales or a spike in oil prices could revive bets on a September hike, boosting the greenback.
Attention will also shift to the Bank of Japan’s next policy meeting. If Japanese authorities deliver a rate hike alongside hawkish guidance, the yen could stage a meaningful recovery. For now, the FX market remains anchored by US inflation trends and the Federal Reserve’s data-dependent approach.
— Hiro Tanaka, markets desk, AXO News