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Today's edition of the Saxo Morning Call features the SaxoStrats team discussing the continuing weakness of the US dollar as commodity prices recover ground and in the wake of key US equity indices hitting all-time highs Thursday.
Article / 31 July 2017 at 1:30 GMT

EURUSD rally a headache for ECB, comfort for the Fed

Managing Director / Technical Research Limited
New Zealand
  • Inflation updates from the US and Eurozone are due 
  • The USD decline will show up in inflation forecasting models
  • The decline in the USD may have more room to run

By Max McKegg

This is a busy week for economic data, starting off with inflation updates out of the Eurozone (Monday) and the US (Tuesday). In both cases the annual rate of increase is expected to show little change from the previous month. 

But change is coming as the impact of the recent rally in EURUSD works its way into the numbers. Staff analysts at the European Central Bank and US Federal Reserve will be reworking their models in the next couple of weeks ahead of the release of updated economic projections in September. The Fed will like what it sees; the ECB not so much.
 
The chart below illustrates the current inflation situation in the Eurozone. With both headline and core still well below target, the EURUSD rally, with its disinflationary implications, has come at an inopportune time.
 
EU inflation
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Source: Bloomberg
 
On September 7, the ECB will publish an updated set of economic projections prepared by its staff. It is this publication that the bank’s Governing Council uses as a guide to setting monetary policy. ECB President Mario Draghi may have the update to hand when he speaks at the August 24-25 Jackson Hole conference.
 
A lot has changed since the previous release in June, when headline inflation was forecast to average 1.5% this year, 1.3% in 2018 and 1.6% in 2019.
 
There are two key technical assumption inputs into the projection model: the path of the exchange rate and Brent crude over the next two years. The EURUSD exchange rate at the time the projections are being put together is assumed to hold steady over that period while the oil price is assumed to follow the Brent crude futures curve out to the end of 2019.
 
In June, the technical assumption for EURUSD was 109.00 and for oil $51.50/barrel; in both cases the average price applying in the two-week period prior to the mid-May cut-off date. This week begins the two-week period leading up to the cut-off date for the September forecasts.
 
What will the September forecasts look like if EURUSD holds its current level of 1.1700 and the December 2019 Brent crude contract stays at $53.70/barrel?

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Mario Draghi won’t like the look of lower inflation projections in the September update, having gone on record a month ago as saying “reflationary forces are at play”. Photo: Shutterstock 

Fortunately the ECB staff do the calculations for us in the “sensitivity analysis” section of their quarterly projections. Here they input an alternative path for the exchange rate and oil into the forecasting model. Always looking on the bright side, the alternative path shows the exchange rate falling and the oil price rising, both combining to push inflation up from the baseline forecast.
 
But this time around EURUSD hasn’t held the 1.09 level used in June, let alone fallen. It has jumped to 1.1700. If this higher level is the technical assumption used in the September projections the model will produce a lower inflation track than June. 

On the other hand, Dec 2019 Brent is currently trading at $53.70/barrel, compared with June’s assumed $51.50, and using the higher number would raise the inflation track.
 
The net effect is likely to be lower inflation projections in the September update: 2018 down from 1.3% to 1.1% and 2019 down from 1.6% to 1.3%.
 
ECB President Mario Draghi won’t like the look of this disinflationary track, having gone on record a month ago as saying “reflationary forces are at play”.
 
However, staff may be able to help him save face by upping the GDP forecast to show the Eurozone growing at around 2% per annum in 2018 and 2019. This would be above potential and therefore the forecasting model would show a positive impact on inflation. Tuesday’s second-quarter Eurozone GDP number will give us an idea of how viable this tactic would be.
 
Of course, there’s a possibility that the EURUSD rally will run out of steam and save the day, perhaps by reverting to historical interest rate differential relationships. As this chart shows, EURUSD does look stretched on differential.
 
EURUSD and bond spread
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Source: Wall Street Journal
 
While the Governing Council of the ECB relies mostly on staff projections as its guide for setting monetary policy, the various members of the Federal Open Market Committee, voters and non-voters, will arrive at their September 19-20 meeting armed with individual forecasts. 

These are collated and the median outcome becomes the Fed’s “central assessment”. No sensitivity analysis is included (although a “margin of error” band is provided, based on the Committee’s forecasting record).
 
An update on the US inflation environment will be provided on Tuesday via the price index on Personal Consumption Expenditures (PCE), the Fed’s preferred indicator. This chart shows the current situation. Little change in the headline and core rates is expected. An outcome that matches expectation would be a relief because, as the chart shows, the trend has not been a friend of late.
 
PCE since 2000
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Source: Advisorperspectives.com
 
Since hitting an interim peak last December, the US dollar – as measured by its Trade Weighted Index – has fallen by about 9%. The Chinese yuan has the biggest weight in the index at 21% but the euro is not far behind at 18%. 

Therefore we can assume the rise in EURUSD, if it holds, will flow through into higher import prices in the US in the months to come and, in turn, show up in the inflation numbers. This should be reflected in the Fed’s updated economic projections due for release on September 20.
 
So far the decline in the US dollar has been modest, providing a small comfort to the Fed and a minor headache to the ECB. But the dollar move may not be finished yet. As this chart shows, the USD index is approaching key support levels.
 
USD Index
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Source: Metastock. Create your own charts with SaxoTrader; click here to learn more  

– Edited by Gayle Bryant

Max McKegg is managing director of Technical Research Limited. If you would like an email notice each time Max posts a trade or article then click here or post your comment below to engage with Saxo Bank's social trading platform.
2y
Morris Morris
A break of 90-85 will signal continuation of the Down trend and may postulate the entire move from 2017 as wave 5? Conversely may suggest end of wave 4 and commencement of wave 5 up! So that 90 -85llevel remains a very key Elliot's pattern level! Great Chart thanks!
2y
Patto Patto
If the US inflation report disappoints, markets are likely to finally price out a rate hike this year and USD will take another hit.

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