US dollar, yields look set to close the gap with commodities

Yet more hot inflation data presented itself for the US on Friday, which surely buries last-gasp hopes of any dovish comments from the Fed at this week’s interest rate decision. Not that a decision really needs to be made, as rates are likely to remain at the 5.25% - 5.5% band for the remainder of the year. But let’s talk about the elephant in the room; hikes. Whilst I do not think another hike is on the radar for the Fed (at least for now), it is surely at least at the back of the Fed’s minds as a contingency plan – should inflation fail to soften.

As things stand, Fed fund futures imply a hold this week with a 97.5% probability, with a hold in June and July currently sitting at 88.2% and 74.6% respectively. A cut in September has fallen to 45.9%, and odds of a cut diminish for each consecutive meeting down to 31.6% in April 2025. Markets are not yet pricing in hikes, but it may be something to keep tabs on should economic data remain firm and inflation point higher in due course.

As mentioned in prior analysis in Mid March, the US dollar appeared undervalued given the rally in commodity prices, as higher commodities equates to higher inflation and therefore higher interest rates. We may not be in need of the higher rates yet, but the US dollar seems to have at least closed the gap with the surge in commodity prices. And that means traders need to keep a close eye on commodity prices going forward to ascertain the likelihood of another round of inflation, and therefore the potential for further Fed tightening.

Related analysis:

The US dollar could be undervalued if commodities continue to rip higher

US dollar ponders correction as bond prices approach support

US dollar technical analysis:

I have overlaid the CRB commodities index (blue) and the US 2-year yield (purple) on the US dollar index to show they are trending in the same direction, even if not completely in lockstep. It is interesting to note that the CRB index has failed to break to new highs as its rally effectively paused this month, which provides a glimmer of hope that inflation expectations are plateauing. Part of the reason may be that traders are now more convinced that the Fed are taking another round of inflation more seriously, via a slew of hawkish comments all pushing back on rate cuts. If the Fed strike a hawkish tone at this week’s meeting, we may even see commodity prices retrace lower alongside risk.

Of course, the US 2-year yield (purple) is currently consolidating around the 5% mark. A break above which paves way for another leg higher. But that means the that US 2-year would need to decouple from the correlation with the CRB commodities index. As I outlined a couple of times recently, yields may be capped due to big support levels on bond prices, and if investors are more convinced that the Fed are going to control inflation it could tempt bond bulls off the sidelines and inadvertently cap yields. This idea needs more time to develop, but it may explain why the US dollar and yields were lower after hawkish comments from Jerome Powell.

But if we look at the relationship between commodities and yields this year, commodities have led the way and the US 2-year and dollar index are trying to close the gap with the CRB index, which leaves the potential for a move to 107 on DXY or 5.2% on the US 2-year yield.

Still, the US dollar index daily chart clearly shows a bullish outside day on Friday which found support around its 20-day EMA and 38.2% Fibonacci level. And this could be the final stages of a bull flag to mark a break above 106 for the US dollar, and for the US 2-year yield to rise above 5%. This could then close the gap with the RCB commodity 9iindex which suggests a move toward s107 for the US dollar index.

The US dollar is hinting at a leg higher looking across the FX major:

• EUR/USD formed a bearish engulfing candle on Friday around the 50% retracement level, and closed beneath the monthly S1 pivot and 20-day EMA
• GBP/USD formed a spinning top doji on Friday around its 50% retracement level and monthly S1 pivot (the daily high was just below the 200-day EMA)
• USD/CHF is consolidating near its cycle highs in a tight range just beneath the monthly R1 to hint at a bullish breakout, after a spike lower showed strong demand around 0.90
• USD/CAD ha retraced around -1.5% from its April high, but its pullback is showing signs of stability above the monthly R1 pivot and 61.8% Fibonacci retracement level
• USD/JPY accelerated higher on Friday thanks for the BOJ not committing to further tightening and the hot US CE report (risks of verbal intervention remain in place)
• AUD/USD rise for a fifth day yet met resistance around the monthly pivot point and 100-dy EMA
• NZD/USD formed a tweezer top at the 50% retracement level, with Friday’s candle being a spinning top doji

-- Written by Matt Simpson

Follow Matt on Twitter @cLeverEdge