'King dollar' returns as US inflation shock sends greenback to 19-month high

The dollar surged to its highest level in 19 months after US inflation came in above market expectations, fueling bets that the Federal Reserve will raise its benchmark interest rate next month. Markets are now pricing in the possibility of a 50-basis-point "big step" hike, raising the prospect of a sustained dollar rally.

The dollar index (DXY), which measures the greenback against a basket of six major currencies, climbed as high as 102.87 during trading Wednesday (local time), according to the Wall Street Journal. That is the highest level in roughly 19 months, since April last year, and the index appeared on track to close at its highest since that time as well.

The dollar strengthened 0.6 percent against both the euro and the Japanese yen on Wednesday. The euro fell as low as $1.1082 per euro during the session, its weakest level since May last year.

The trigger was a hotter-than-expected US inflation reading. The October consumer price index (CPI), released Tuesday, rose 0.4 percent from the previous month, topping the 0.3 percent gain that economists surveyed by the Wall Street Journal had forecast. Core CPI, which strips out volatile food and energy prices, also rose 0.3 percent, exceeding the 0.2 percent market consensus.

The data reinforced expectations that the Fed may need to tighten policy more aggressively, with voices inside the central bank itself calling for a larger-than-anticipated rate increase.

Fed Governor Christopher Waller, speaking at a conference in London on Tuesday, said he supports a 25-basis-point rate increase in December. He added, however, that a 50-basis-point hike should be on the table if October's core inflation reading comes in at 0.3 percent or higher.

Financial markets have in effect priced in a December rate hike as a foregone conclusion. According to the London Stock Exchange Group (LSEG), markets on Wednesday assigned an 88 percent probability to a 25-basis-point increase and a 12 percent probability to a 50-basis-point move, with no meaningful weight placed on a pause.

Still, some analysts caution that further dollar gains will require an even more hawkish shift in Fed expectations, given how much the currency has already risen.

"With a December rate hike already seen as the base case, expectations for a 50-basis-point increase may need to grow further to drive additional dollar strength," said Bas Kooijman, asset manager at DHF Capital.

Kooijman said the dollar could break above its recent highs if the US producer price index (PPI), due out Friday, surprises to the upside or if Fed officials continue to deliver hawkish remarks that push US government bond yields higher. Conversely, weak economic data or growing opposition to further rate hikes could take some of the momentum out of the dollar's advance.

Concerns about slowing growth in Europe and political uncertainty are also lending support to the dollar. The euro has weakened as falling global oil prices have reduced expectations for further ECB rate hikes, while worries about France's debt burden continue to weigh on the currency.

Markets are pricing in a 78 percent probability that the ECB will raise its benchmark interest rate by 25 basis points at its December policy meeting, though the outlook for further tightening beyond that remains uncertain.

"The ECB may show reluctance to raise rates beyond December," said Jane Foley, foreign exchange strategist at Rabobank, noting that policymakers at a recent ECB press conference appeared increasingly concerned about Europe's economic growth outlook.

The prospect of a far-right candidate winning next year's French presidential election — and the uncertainty that could create for EU cohesion — was also cited as an additional headwind for the euro.

Reflecting these economic and political uncertainties, Rabobank forecast the euro will fall to $1.10 per euro within the next three months.