Ebury: Stocks up, dollar down as Federal Reserve turns ever more dovish

Last week capped an unusually busy month of August in financial markets. A combination of massive easing from the world central banks and guarded optimism about a COVID vaccine has brought the biggest August rally in US stocks in decades, but has been unambiguously negative for safe havens and, more meaningfully, the US dollar. The Federal Reserve did the greenback no favors announcing a significantly dovish shift in its future policy, promising that it will now tolerate periods of above-target inflation in order to compensate for the time that inflation remains below the 2% target.  
The sell off in the US dollar has been particularly strong against currencies with significant commodity exposures, as the sector is expected to benefit from the Fed's increased tolerance of inflationary pressures. The one exception has been the Brazilian real, which continues to be pressured by fiscal concerns and the country's poor response to the pandemic.
Traders returning from holidays will have a full plate of macroeconomic news next week. Eurozone PMI indices of business activity and inflation for the month of August released Tuesday through Thursday will set the stage for the critical August employment report out of the US on Friday.
GBP
Sterling has been one of the main beneficiaries of the risk-on mood in markets this summer, and has outperformed all non-commodity G10 currencies to rise to a two year high against the US dollar. In doing so, it looked past the lack of any visible progress in the Brexit negotiations and some mixed economic data. This week is unlikely to bring fresh news on either the pandemic or the Brexit negotiations. Given that speculators seem to be very short the US dollar, and the very sharp rally of STerling over the past few weeks, there is a good chance of temporary pull backs on any disappointment over economic news or Brexit negotiations.

EUR

The scorching rally in the Euro against the dollar received a fresh impulse from the Federal Reserve's announcement of a "flexible targeting" policy that will be more tolerant of above-target inflation in the future. While we remain positive on the common currency for the long term, the speed of the recent move, the stretched short dollar positioning of currency speculators and the mixed nature of recent economic and pandemic news out of the Eurozone may make it vulnerable to short term pullbacks. The August inflation report out this week is unusually hard to predict, and a surprise in any direction may provide a catalyst for a sharp market move in the currency.

USD

The momentous change in inflation management announced last week by the Federal Reserve increases our confidence in our long-term bearish view of the US dollar. The Fed stated that it will tolerate inflationary outcomes above its target of 2% so as to maintain the average around target. What this means for the medium term is that the barrier for any future interest rate hikes is even higher than the market anticipated. Higher inflation will no longer on its own be sufficient to warrant them. Financial markets have reacted as one would expect, sending the prices of commodities and stocks higher while long term bonds and the US dollar sell off. 

For the short term, we think resistance to further sell offs in the dollar is building up as speculators become ever more stretched in their consensus dollar bearish positioning. A positive job market report on Friday may provide a catalyst for a short-term short covering rally in the dollar.