Fed hike odds fall to 48% as hot CPI threatens rate path

The Federal Reserve faces an inflation test Wednesday as futures markets cut the probability of a September rate hike to 48 percent from 67 percent a week ago, after July's unexpected 23,000-job payroll contraction.

"A hot CPI report could cause problems for the Federal Reserve," Jim Caron, CIO of portfolio solutions at Morgan Stanley Investment Management, said. "Higher nominal growth is driving equity prices higher."

The dollar index held near a two-month low at 99.62, while benchmark 10-year Treasury yields stayed at 4.647 percent after the jobs report dashed hike bets. The euro traded at $1.1563, near its strongest level since mid-June, while the yen weakened 0.6 percent to 158.89 per dollar. Consensus estimates call for core CPI to rise 0.2 percent month-on-month in July, with the annual rate moderating to 2.5 percent from 2.6 percent in June.

A hot print would reverse the market's dovish repricing and push the Fed back toward a hike as its baseline, according to Francesco Pesole, FX strategist at ING. Producer price data Thursday and retail sales Friday will further shape the inflation outlook, with the next Fed decision scheduled for September.

Rate Path Hinges on Wednesday's Print

The soft labor market data adds extra weight to the CPI report as investors look for clues on the path of Fed policy. "It was a negative event for the dollar," Pesole said. "We think the bias remains negative this week but if we get a hot break on CPI, markets are going to be back to pricing in a rate hike as their baseline."

The July payroll report showed the U.S. economy lost 23,000 jobs, a sharp reversal from the 80,000 to 95,000 gain economists had projected, while job gains for the prior two months were revised sharply lower. Weaker labor data typically strengthens emerging market currencies by reducing the dollar's appeal and raises the odds the Fed adopts a more accommodative stance.

Dollar, Yen React to Shifting Odds

Speculators slashed their bearish bets on the yen by the most in over 12 years, according to Commodity Futures Trading Commission data. The net short position in the yen fell by $8.865 billion to $3.604 billion in the week to August 4, the largest drop in absolute terms since March 2014, reflecting the coordinated effort by Japanese and U.S. authorities to strengthen the currency.

Meanwhile, speculators increased their net long position in the dollar to the highest level since December 2022, the CFTC said. The dollar index hit its lowest level since June 15 on Friday before steadying at 99.62.

Oil prices added to the inflation backdrop, with Brent crude futures up 1.5 percent at roughly $85 per barrel with continued uncertainty over the reopening of the Strait of Hormuz. Iran said a deal with Oman defining new shipping lanes was in its final stages but added that the U.S. must still meet other conditions, muddling the energy supply outlook.

Elsewhere, the Australian dollar traded at $0.7065 before the Reserve Bank of Australia's rate decision Tuesday, with the central bank expected to hold its key rate at 4.35 percent for the rest of the year. The Chinese yuan held steady at 6.7442, near its strongest level in 3-1/2 years, after data showed China's producer price inflation eased last month.

If core CPI comes in at or above 0.3 percent month-on-month, the market's 48 percent September hike probability could quickly rebound toward 60 percent or higher, forcing a sharp dollar rally and pressuring emerging market currencies. Conversely, a benign print at or below the 0.2 percent consensus would cement the dovish repricing and extend the dollar's decline.

This article is for informational purposes only and does not constitute investment advice.