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 / 01 September 2017 at 1:54 GMT

US and Eurozone inflation updates put another brick in the wall

Managing Director / Technical Research Limited
New Zealand
  • Markets are pricing in only 20 basis points of Fed hikes in the next 12 months
  • That is way down from the 70 basis points priced in earlier in the year
  • Markets are trying to assess the impact the euro rally on growth and inflation
  • The US nonfarm jobs number could impact EURUSD
By Max McKegg
The latest inflation updates from the US and Eurozone will have given no encouragement to traders betting on a rate hike from the Federal Reserve or quantitative easing tapering by the European Central Bank this year. This will be reflected in updated economic forecasts presented by the ECB next week and the Fed on September 20.

As shown in the chart below, headline and core inflation in the US, as measured by the price index of Personal Consumption Expenditures (PCE), the Federal Reserve’s preferred inflation gauge, continues to head in the wrong direction.

PCE chartnnn


In the Eurozone, the flash estimate of inflation through August showed the headline rate increasing slightly to 1.5% (largely due to a 4% rise in the energy component) while the core rate flatlined at 1.2%.
EU inflation chartnnn

Source: Financial Times

As inflation numbers in the US continue to disappoint, the forward interest rate curve has adjusted accordingly.

As shown in the chart below, the market is pricing in only 20 basis points of hikes by the Federal Reserve over the next 12 months, way down from the 70 basis points priced in earlier in the year. In the Eurozone, the expectation is that EONIA, the interbank rate, will rise only 3 basis points from the current minus 0.36%.

US and EU forwards chart


Source: Morgan Stanley

At face value, the increase in the annual headline inflation rate in the Eurozone to 1.5% in August from 1.3% the previous month should have been good news. But markets are forward looking; in particular they are trying to assess the impact the recent rally in the EUR will have on economic growth and inflation over the next couple of years. Then they will have to match their forecasts with those due to be released by the ECB next Thursday.


Forex traders will focus on European Central bank forecasts, and ECB president Mario Draghi doesn’t have much room to manoeuvre on monetary policy. Photo: Shutterstock
The trade weighted value of the EUR has increased by about 5% since the ECB released its last set of forecasts in June. Measuring the impact of this on inflation is not straightforward. As shown in the table below, estimates vary widely, depending on which model is used. It seems the ECB’s model is likely to show a moderate impact, perhaps clipping only 0.1% off the June forecasts, taking the core inflation estimate for 2018 down to 1.3% and 2019 to 1.5%.

Most economists would see that as being conservative, with a 0.3% impact being more likely, especially at the EUR has continued to rally since the cut off date for the September forecasts (mid-August). See more on this here: EURUSD rally a headache for ECB, comfort for the Fed.

The euro and inflation table nnn
 Source: Credit Suisse

In the end it will be the ECB’s forecasts that traders concentrate on because they will be the basis for monetary policy. On this occasion, however, the commentary – or spin – around those forecasts will be just as important. Bank President Mario Draghi will not want to say anything in the post-meeting statement or his follow-up press conference that would encourage markets to take EUR higher. But he doesn’t have much room to manoeuvre. Rate hike expectations are already low and re-opening the possibility of rate cuts would be a embarrassing backdown from earlier guidance.

The other option, warning of extending asset purchases through 2018 rather than tapering, would not be viable either as the ECB’s bond holdings would get very close to country limits by mid-year, leaving buying concentrated on just three or four countries. That might present political problems.

To some extent then, Draghi’s hands are tied so it would not surprise if EURUSD was to resume its uptrend next Thursday. But the immediate direction of the cross will be determined by the USD side, when Friday’s US nonfarm employment data is released. As this chart of the USD index shows (click to enlarge), the dollar is delicately poised

USD chart
Source: Metastock. Create your own charts with SaxoTrader; click here to learn more.

Inflation updates from the US and Eurozone were another brick in the wall for monetary policy. Market pricing suggests ever diminishing probability of rate hikes. The ECB (on September 7) and Federal Reserve (September 20) will shortly issue updated economic forecasts. Both are likely to lower inflation profiles and dampen expectations of any change to policy.

For more on forex, click here.

– Edited by Robert Ryan

Max McKegg is managing director of Technical Research Limited. Follow Max here or post your comment below to engage with Saxo Bank's social trading platform.


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