Fed Tightening Cycle Looms as Dollar Surges on Inflation and Middle East Tensions
The US dollar has surged in response to inflation data and escalating tensions in the Middle East. The attacks by Yemeni Houthis on Saudi Arabia have forced the country to shut down its East-West pipeline, which has a capacity of 7 million barrels per day.
This development threatens to reduce oil supplies to the global market, pushing Brent crude towards $120 per barrel. Under these circumstances, the Federal Reserve will be compelled to initiate a new cycle of monetary tightening.
When Kevin Warsh stated at Jackson Hole that he hadn't been misled by the slowdown in inflation in June and July, and that current interest rates weren't holding back the economy, he set a high bar. The latest figures came in line with expectations, leaving almost no room for doubt about an impending rate hike.
CME derivatives have increased the probability of a monetary policy tightening from 60% before the PPI data release to 87%. This has reignited interest in the US dollar, and speculators have been unwinding their net long positions in the greenback for six weeks running. These positions have fallen by $50 billion compared with the end of July, when they were at their highest since 2014.
The rate hike offers a different perspective on the US dollar. A WSJ journalist who is regarded as a Fed insider points out that the FOMC will not stop at a single rate rise but will continue down this path until it has defeated inflation. The market currently prices in two rate rises and a small probability of a third by March 2027.
The strengthening of the US dollar has allowed the bulls on USDJPY to launch a counterattack. Morgan Stanley forecasts a return of USDJPY to 163. According to the bank, the fall was caused by the unwinding of speculative short positions in the yen following rumors of the GPIF's portfolio diversification.
At the same time, fundamental factors are working against the Japanese currency, and a large-scale repatriation of capital appears unlikely. The release of inflation data has been a rollercoaster ride for gold, historically being a headwind for the precious metal in the early stages of a Fed tightening cycle.