Canadian Dollar trims gains, US Dollar firms up ahead of US CPI numbers

The US Dollar strengthened across the board ahead of the US Consumer Price Index (CPI) report due later in the day, causing the Canadian Dollar to lose some of its recent gains. The USD/CAD pair had risen about 15 pips, reaching above 1.3930, but the overall trend remained bearish after falling more than 1% in two weeks. Investors were reducing their US short positions in anticipation of the US CPI figures, which would shed more light on the Federal Reserve's future monetary policy stance.

Experts at ING pointed out that the markets were already set for "a softer price story" and that seeing a 0.1% month-on-month rise in core inflation would push the probability of a September Fed rate hike down to 50%. The US Dollar also benefited from heightened demand for safe-haven assets due to escalating tensions in the Middle East.

Iran-backed Houthi rebels attacked an Egyptian vessel in the Red Sea, resulting in casualties, which raised concerns about the reopening of the Strait of Hormuz and the potential prolongation of the conflict. Conversely, the Canadian Dollar continued to be bolstered by rising oil prices, as Canada is its primary export. The Canadian Dollar had increased nearly 2% since the US initiated the ceasefire in early July.

Inflation gauges the escalation in the price of a standard assortment of goods and services, typically expressed as a percentage change on a month-on-month or year-on-year basis. Core inflation, which excludes volatile components like food and fuel, is the primary focus for economists and the benchmark that central banks aim to maintain at a manageable level, usually around 2%.

The Consumer Price Index (CPI) measures the changes in prices of a basket of goods and services over time, usually expressed as a percentage change on a month-on-month or year-on-year basis. Core CPI is the target figure for central banks, as it excludes the fluctuations caused by seasonal or geopolitical factors. When Core CPI exceeds 2%, higher interest rates are usually implemented, which positively impacts the currency's value.

Conversely, when Core CPI falls below 2%, lower interest rates might be considered, negatively affecting the currency. Despite seeming counterintuitive, high inflation in a country tends to appreciate its currency, while low inflation usually depreciates it. This is because central banks generally raise interest rates to combat higher inflation, attracting global capital inflows from investors seeking lucrative investment opportunities.