Inflation and the dollar: Is the connection as direct as it seems?

US inflation soared in April and so did market volatility. Treasury rates rose, the dollar followed and equities dropped for a second day.  The Fed insists prices increases are temporary but behind the pandemic base effect commodity prices are sharply higher and wages are rising.  Inflation has not been a market consideration for a decade, is that changing? Join senior FXStreet analysts Valeria Bednarik, Yohay Elam and Joseph Trevisani for an in-depth look at the global price picture.

Yohay Elam: How is the US economy doing? Nonfarm Payrolls were weak, inflation was strong, and both figures are for the same month.
The confusion has caused volatility in markets, which is good news for forex traders.

Joseph Trevisani: Oli prices for one are headed higher, and oil is the basic industrial commodity.

Yohay Elam: But what is the trend?

Joseph Trevisani: Good question.

Yohay Elam: I have an answer – NFP was an outlier and will be revised higher next month. The US economy is on fire.

Valeria Bednarik: The number of jobs opening soared to record highs in March. That put in doubt the weak NFP. I do agree with you. Could have been a temporal hiccup.

Joseph Trevisani: I think higher. This is the logic. Current shortages are driving prices for many commodities higher, the Bloomberg Commodity Index is at a more than five-year high. When those shortages are addressed, which will take time, prices will not return completely to their prior levels. The NFP numbers look dicey, more than 800,000 jobs were adjusted into oblivion. The statistical assumption behind seasonal adjustments was never designed and I do not think are capable of accounting for the events of the last year.

 

Five year BCOM

Valeria Bednarik: Commodities prices are soaring in hopes of a return to normal, resurgent demand. It's all a big mess as markets, economies are in the middle of an adjustment process, from pandemic chaos to normal. The global pace is uneven and won't be an easy one, but it's happening.

Yohay Elam: However, as the NFP looks like an outlier related to seasonal adjustments, I buy the Fed's stance that inflation is transitory. Car-hiring prices jumped 10%, which is a one-off. Other prices increases are related to the reopening, which will likely fade.

Joseph Trevisani: I think we have both a base effect and rising long-term prices. Oil is headed higher and that is basic to everything.

Valeria Bednarik: It's a bit of both. Anyway, it will take some time to confirm whether higher inflation is temporal as the Fed believes. The immediate reaction to higher inflation was short-lived across currencies. Let's see what Wall Street does.

Joseph Trevisani: Treasury rates are higher, the 10-year is up 3 basis points...

Yohay Elam: The dollar has pared most of its gains.

Valeria Bednarik: Yes, 1.65%...still below the 1.70% line-in-the-sand.

Joseph Trevisani: The base effect is real, but so is the additional. Prices never return to the prior start line after a bout of inflation.

Valeria Bednarik: Fed’s Clarida is speaking right now, and has just said that if inflation was pushed to levels inconsistent with the Fed's mandate, they would use tools to bring it down.

Yohay Elam: He also said he hasn't looked into the details.

Joseph Trevisani: Which leaves a great deal of room for policy.

Yohay Elam: One detail is that car prices are responsible for one-third of the jump.

Joseph Trevisani: Great...I need a new car.

Valeria Bednarik: So, details support the ongoing Fed's stance and should not force their hands into tightening.

Joseph Trevisani: Either way, the Fed has painted itself into a bit of a corner with inflation averaging and insistence on full recovery before ending accommodation.

Valeria Bednarik: Good thing is that they can change their mind anytime

Joseph Trevisani: Another problem is the violence in the Middle East which could easily impact oil.

Valeria Bednarik: But I don't think they will surprise us. They will go in slow-mo.

Joseph Trevisani: The Fed has an ally on inflation...the Treasury market. One or two hints and it will take rates higher. It may do so anyway.

Yohay Elam: The world is less dependent on Middle Eastern oil, and the conflict is centred on Israel and Gaza rather than in the Persian Gulf. Nevertheless, a spark in the region can quickly escalate. As an Israeli, I hope things calm down shortly.

Joseph Trevisani: Iran wants to destroy the Abraham Accords, they are a direct threat to the mullahs. There is no coincidence here. Biden signals he wants to talk to Tehran, Iran and Hamas attack.

Yohay Elam: But Iran and Saudi Arabia have shown some signs of reconciliation.

Joseph Trevisani: Iran? They support Hamas, the rockets are supplied from Tehran.

Valeria Bednarik: Back to markets, I do agree with Yohay that the conflict will have a limited impact on oil prices. Demand and demand forecasts are what we need to look at.

Yohay Elam: I think that demand is strong.

Joseph Trevisani: I agree at least for the time being.  Oil is higher but not much and the price is cushioned by North American fracking, even with the administration's ban on new federal leases.

Yohay Elam: "Build it and they will come". Demand is strong, so supply will arrive to meet it. Bottlenecks will be resolved.

Valeria Bednarik: Yes as always. In the meantime, we have our fun moments.

Joseph Trevisani: Yes I don't think there will be a shortage spike in oil.

Yohay Elam: An interesting phenomenon that I've seen: The dollar dropped in response to the NFP, bounced back, and then took a bigger dive. Inflation: Dollar up, down and down again. It looks like currency markets are giving traders an opportunity to jump in.

Joseph Trevisani: We don't have a trend for the moment as we did for the first three months. Higher US rates are the key to the dollar.

Valeria Bednarik: Well, as we have been discussing in the last couple of months, the dollar will recover its self-strength on sustained signs of economic progress.  The more data we get from the US, the closer we are to that. I would not bet much on shorting the greenback at these levels.

Joseph Trevisani: I agree...I think it is a buying moment for the dollar...

Valeria Bednarik: The dollar is firmer, despite stocks are moving off early lows. It may not last long, but is a first indication that we are approaching an inflexion point.  Gold, however, remains at the upper end of its latest range firmly trading above 1,8000.

Yohay Elam: The next big release is US retail sales. Will that go the way of NFP or that of inflation?

Joseph Trevisani: One thing that has been constant is the difficulty of predicting statistics through the pandemic and recovery. Historical models are largely useless. I think retail sales will be higher than forecast. Not the least because of inflation.

Yohay Elam: I also bet on big retail sales numbers. Never underestimate the American consumer.

Valeria Bednarik: Agreed, we could have another healthy figure.

Yohay Elam: Indeed, the pandemic is skewing stats, which causes volatility. Is this newfound volatility here to stay?

Joseph Trevisani: Nothing is forever..but until the economy reaches stability. Treasury rates are moving higher..10-year 1.672%.  As Val said, 1.7% and I think we get a  strong dollar reaction. Equities agree, all indexes are down.

Valeria Bednarik: Yes, we will have volatility in the process, as usual. Hopefully, it will keep increasing.

Yohay Elam: Regarding gold, I think bulls have taken over, and have more room to run.

Joseph Trevisani: We do have a small Armageddon trade...

Valeria Bednarik: I'm not sure if it could keep running unless something triggers panic.

Joseph Trevisani: Even though the impact on oil has been limited...the situation in Israel, if it continues and especially if it escalates, should push gold higher. When we return to the base scenario, a quickly reviving US economy, market logic seems straightforward..higher US rates, with or more likely without the Fed's endorsement..then higher dollar.  However, its very obviousness worries me.

Yohay Elam: Hopefully volatility stays elevated.

Valeria Bednarik: Yes, that's what we need for now. And take advantage of it.

Joseph Trevisani: I think it will.  Russia and Iran seem to sense an advantage. I hope it's not true but actions speak louder.  And on the other side of the world is China. I expect we will be hearing from Beijing soon. Conflict is good for volatility.