Markets in Focus: Inflation Trends and Policy Signals.

• USD Momentum Strengthens: Upcoming US inflation data (CPI and PPI) could extend the dollar’s rally, with PPI expected to show an uptick, supporting the Fed’s inflation focus. The dollar index (DXY) may reclaim levels above 110.
• Strong US Small Business Outlook: Optimism and hiring plans from small businesses—key contributors to US GDP and employment—are at multi-year highs, reinforcing confidence in the economy despite minimal direct Fed impact.
• Hawkish Fed Signals: Comments from hawkish Fed officials may emphasize the robust jobs market, contrasting dovish views and further bolstering the dollar.
• Euro Faces Domestic Weakness: Limited eurozone data and dovish ECB commentary suggest subdued EUR/USD performance, with the euro undervaluation gap potentially narrowing if US yields rise.
• GBP Pressured Ahead of UK CPI: Rising gilt yields and inflation concerns are weighing on sterling, with GBP/USD at risk of dropping to 1.200 as higher borrowing costs tighten fiscal constraints and market sentiment.

USD: Inflation Data Could Propel Dollar Rally
This week’s US inflation data has the potential to extend the dollar’s bullish momentum and challenge expectations of Fed rate cuts. While tomorrow’s CPI data will likely have the greatest market impact, today’s PPI report remains critical, given its influence on the Fed’s preferred inflation gauge—core PCE.

Analysts expect core PPI to rise from 0.2% to 0.3% month-on-month in December, which could sustain demand for the dollar ahead of CPI. However, there is a chance that CPI may deliver a softer-than-expected outcome.

In addition, the December NFIB Small Business surveys are due, with optimism recently hitting its highest level since mid-2021. Small businesses, which contribute 44% of US GDP and employ 46% of the workforce, have shown increased hiring plans. Although this isn’t directly impacting Fed policy, strong data could reinforce confidence in the labor market and economic activity.

On the Fedspeak front, hawkish-leaning members Schmid and Williams are set to comment, with their focus likely on the tight jobs market. Their remarks could contrast with the more dovish Goolsbee, who downplayed the December jobs report as evidence of overheating.

The dollar index (DXY) may climb back above 110.0, recovering from yesterday’s modest pullback.

EUR: ECB Maintains Dovish Stance
With a quiet eurozone calendar this week, EUR/USD movements will remain largely dictated by dollar strength.

Domestically, the euro faces limited support. ECB Chief Economist Philip Lane highlighted growth concerns in his recent remarks, noting that sluggish economic expansion risks undershooting the inflation target. Additionally, Olli Rehn suggested interest rates could fall to neutral by mid-2025.

Market expectations for rate cuts this year remain entrenched, with little room for a rise in the EUR 2-year swap rate beyond 2.50%. If US data drives a hawkish shift in dollar rates, the euro’s undervaluation gap (around 2.5%) could narrow further.

GBP: Volatile Markets Ahead of CPI Release
UK gilts continue to face selling pressure, with 10-year yields approaching the 4.90% mark ahead of tomorrow’s CPI report. A hotter-than-expected inflation reading could push yields past 5.0%, adding further downside risk to sterling.

Although sterling typically benefits from inflation surprises, its indirect link to rising rates suggests a bearish outlook. Higher borrowing costs are straining the UK government’s fiscal flexibility, raising the risk of spending cuts this spring—another negative factor for the pound.

While market conditions for gilts and sterling may stabilize in the coming weeks, GBP/USD (Cable) could dip to 1.200 in the short term before finding stronger support.