The biggest story of the past trading week on the financial markets was U.S. inflation. Rumors and talks about fast inflation increase caused worldwide equities deep correction a week before, creating a fear that U.S. economy could have a slowdown. But smart money was acting aggressively from the start of the week, buying equities at lower prices comparing to January peaks, and indices showed strong recovery, while Treasuries continued to slide. 10-year Treasury yields (inverse relation to the price) rallied to almost 3% this week, pricing in more tightening from the Federal reserve together with higher inflation.
The main economic report was U.S. CPI on Wednesday, which showed slightly higher-than-expected reading, and the price action was dramatic across the board. Initial reaction was to sell equities, which dropped 1% in minutes, and buy USD, following additional demand for Treasuries. EUR/USD dropped more than 100 pips from the highest rate in early European session. Smart money stepped in, reversing this move and we've seen completely opposite ending of Wednesday trade, with stock indices rallying more than 1.5%, Treasury yields going up sharply and EUR/USD performing bullish run, breaching 1.2500 important level third time this year.
I've been waiting for something like this, observing overreaction of the market players based on nothing but rumors. The explanation of such unexpected for most traders action is very simple. Yes, inflation picks up the momentum, exactly as FOMC predicted in October. Yes, Federal Reserve will be forced to hike, exactly as they told before. But this also tells about U.S. economy strength, confirming wage growth and stable consumption, which has to lift corporate earnings and create additional demand in equities and thus risk-on market investment sentiment. Treasuries, however, lose their attractiveness as mid- and long-term investment assets, covering just inflation and not producing additional profit. Money must work and what is happening at the markets currently is the that huge volume smart money is looking for repositioning to high-yield assets and more attractive markets.
Next question was about talks that Federal Reserve could be forced to hike more aggressively in 2018 due to faster inflation growth. Such scenario could make borrowing costs much more expensive for corporate sector and consumers, slowing down the economy growth. But as the CPI report was not that scary, it did not give any background for such talks. Fears eased, risk-on sentiment came back to the markets. The greenback as world reserve currency loses its’ attraction. There is a huge flow of capital coming back to equities from long-term savings sealed in U.S. Treasuries. Investors are getting out of cash USD, putting funds to work more effectively. This process creates additional demand for other currencies on Forex market, lowering the rate of USD.
You can find below a comparison daily chart of U.S. Dollar index with 10-Year Treasury yields. There is an obvious change of correlation started from December 11 2018.
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