Following weak inflation figures and no change in guidance from the Federal Reserve, reactions in the US dollar have been fairly predictable. As the threat of aggressive rate hikes fade, falling US interest rates have pushed the US dollar lower. On a day-to-day basis, a lot of currency movements can be explained by changes in relative interest rates. When trading over a short-term time horizon, looking at bonds is thus a great way to understand changes in the US dollar. As bonds are heavily influenced by trends in inflation and monetary policy, currency traders tend to watch these economic indicators closely. From this perspective, the medium-term outlook for the US dollar is mixed at best.

With inflation front-runners pointing to weakness, still too early to get bullish on the dollar

Commodity prices (and crude oil in particular) are a great front-runner for inflation. This is because commodities are a substantial input cost for many products and services, and changes in commodity prices tend to be reflected in higher CPI figures over time. As we wrote in a previous article, the recent commodity bull market that began last summer foreshadowed the acceleration in CPI figures from September. Judging by the sell-off following yesterday’s weak CPI numbers, expectations for inflation were running high. Looking at more recent commodity prices suggests that the trend of accelerating inflation data is likely to come to an end. This is shown below:

 As commodity prices go flat, inflation likely to weaken

(Click on image to enlarge)

Source: TradingView.com

As can be seen above, inflation expectations began falling in the first quarter of 2017 as commodity prices began rolling over. Unsurprisingly, the US dollar entered a bear market at this time. The commodity market rally that began in late June peaked by early November. At the time, both technical indicators and speculator net positioning in crude oil futures were looking extreme. More recently, commodity prices are now reversing. While crude oil remains supported, many agricultural commodities (such as corn, coffee and cocoa) and industrial commodities such as copper have been weakening. As the commodity bull market runs out of steam, the outlook for inflation (and the US dollar) is less benign.

US politics not living up to expectations

While dollar bulls point to Trump’s fiscal spending plans as a catalyst for near-term dollar strength, this perspective is problematic for a few reasons. Firstly, last night’s Fed commentary suggests that Republican tax cuts have been factored into future economic projections. Given the volume of commentary on this issue, there is a good chance that tax cuts have already been priced into the currency. The second issue is that Trump has greatly struggled in getting bills through Congress given divisions within the Republican Party. While he recently touted his infrastructure investment plan (which led to intraday dollar strength), whether or not deficit hawks agree to a larger government deficit remains to be seen.

Looking back at 2017, few would have predicted that the dollar would enter a bear market in the face of accelerating GDP growth and three rate hikes. Instead of historical monetary policy and economic growth, the key factor that drives the currency is the underlying trend in inflation and future expectations. As commodity prices and expectations for fiscal spending remain weak, the dollar is likely to follow.