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 With the Fed's policy statement in March and remarks from Fed
Chair Janet Yellen later in the month striking a cautious tone,
strategists say this has set the stage for a rough patch for the
dollar over the near-term as inflation nips at it.
U.S. inflation has firmed in recent months, with the core Consumer
Price Index rising 2.3 percent in the 12 months through February to
mark the largest increase since May 2012. The core personal
consumption expenditures price index, which is the Fed's preferred
measure, gained 1.7 percent in the 12 months ended in February.
The core inflation readings exclude food and energy prices. The Fed
is targeting a 2 percent core PCE reading.
Inflation typically undermines the dollar's strength by diminishing
its spending power. Differences in inflation rates between the
United States and the euro zone have been the main force behind the
dollar's value against the euro since 2000, according to a research
report from Fundstrat Global Advisors.
 While expectations for higher inflation once tended to ramp up bets
on a swifter pace of Fed rate hikes and, in turn, boost the dollar,
strategists say the perceived improbability of a Fed rate hike until
at least June has reinstated inflation’s traditional role of eroding
the dollar’s value.
"If inflation in the U.S. is relatively high, but interest rates
aren’t expected to move higher... that doesn’t ultimately bode well
for the dollar," said Shahab Jalinoos, global head of FX strategy at
Credit Suisse in New York.
Jalinoos sees the euro hitting $1.17 against the dollar within the
next three months. That suggests 2.7 percent more downside for the
dollar against the euro.
Ian Gordon, foreign exchange strategist at Bank of America Merrill
Lynch in New York, says the Fed could wait before hiking rates even
if core PCE reached its 2 percent target. He notes Yellen expressed
skepticism last month that gains in inflation were sustainable.
A Reuters poll on Friday showed the median expectation among top
Wall Street banks that deal directly with the Fed was for a year-end
inflation rate of 0.875 percent, implying just two rate hikes this
year.
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Gordon says investors have to be cautious in boosting long-dollar
positions "over the coming months until we get more evidence that
the pickup in inflation is sustainable and the Fed is going to
respond to it."
Data from the Commodity Futures Trading Commission released on
Friday showed speculators slashed their bullish bets on the dollar
to the lowest in nearly two years.
The greenback has an advantage over regions such as Europe and
Japan, where yields are extremely low given ultra-accommodative
monetary policies. U.S. 10-year Treasury notes last yielded 1.73
percent, compared with a 0.10 percent yield for the 10-year German
Bund.
But the dollar has already tumbled this year on traders' views that
the Fed would not be able to follow through with the four rate hikes
it projected in December. The Fed confirmed traders' skepticism last
month by cutting projections to just two rate hikes.
The dollar index, which measures the U.S. currency against a basket
of six major currencies, fell 4.1 percent in the first quarter, its
biggest quarterly percentage drop in five and a half years.
Thomas Lee, managing partner at Fundstrat in New York, says the
index would likely fall another 5 percent or so by summer.
"I do see USD downside," Lee said. "(The Fed) is likely to be very
patient" despite rising inflation.
(Reporting by Sam Forgione; Editing by Dan Grebler)
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