EUR/USD: Softer EZ inflation reinforces downward momentum ahead of NFP

The euro has continued to trade at weaker levels overnight after the release of much softer euro-zone inflation data reinforced downward momentum. It has resulted in EUR/USD and EUR/GBP breaking below support from the bottom of their recent trading ranges at 1.1400 and 0.8600 respectively. The latest euro-zone CPI report for June revealed that headline and core slowed more than expected to 2.8% and 2.4%. When taken together with lower energy prices as well, the euro-zone economy appears to be more closely aligned with the ECB’s “milder” scenario. The ECB staff projections from June revealed that headline inflation was expected to be at 3.2% in Q2 in both the baseline and mild scenarios, and core inflation at 2.4%. The latest favourable developments will dampen pressure on the ECB to tighten monetary policy further. The euro-zone rate market has become less confident that the ECB will deliver one final rate hike later this year.

ECB President Lagarde acknowledged in a panel discussion yesterday at the ECB’s annual forum in Sintra that “I think the risks by the way that we have to the upside and to the downside of growth are probably more broadly balanced than they were a few weeks ago”. A downward revision to the ECB staff’s inflation  to the downside of growth are probably more broadly balanced than they were a few weeks ago”. A downward revision to the ECB staff’s inflation forecasts at the September policy meeting would be make it more difficult to communicate hiking rates further, but we still believe that one final hike remains a possibility. ECB Chief Economist Philip Lane has recently cited concerns over second round inflation effects and indicated that their estimate of the top of the range of their neutral policy rate has been raised by 25bps to 2.50%.  As a result, we believe it is too soon to drop our call for a September hike although acknowledge that there is higher risk now that rates will be left on hold through the rest of this year. The recent drop in euro-zone yields and softer cyclical growth momentum in the euro-zone are contributing to a weaker euro in the near-term. After hitting a peak at 2.83% on 18^th June, the euro-zone 2-year government bond yield has fallen by around by just over 30bps. A much bigger drop in yields than in the UK and Us rate markets over the same period.       

Nevertheless, the less hawkish tone of President Lagarde was also evident among other panel discussion participants including BoE Governor Bailey and new Fed Chair Kevin Warsh. BoE Governor Bailey stated that “we’re seeing a softening labour market. We’re seeing some softening of activity. We think we’ve got a bit of an output gap opening up”. He acknowledged as well that energy prices have “come down quite substantially” but believes that the BoE has to be careful given the Uk has delayed reaction mechanism to energy prices so that inflation risks have not yet passed. As result, he believes interest rate cuts are still “off the table”. His comments are consistent with our view that the BoE are likely to leave rates on hold through the rest of this year leaving room for UK rates to continue adjusting lower.

The much anticipated comments from Fed Chair Kevin Warsh also struck a less hawkish tone than after the first FOMC meeting. He stated that “expectations of inflation over the first four weeks of this period, they’ve come down. Inflation risks have come down”. At the same time, he expressed optimism that AI will boost productivity growth in the US. The positive supply shock would have “huge implications” for policy although acknowledged that the AI-capex boom is impacting demand first. However, he refrained from giving clear guidance over near-term policy direction reiterating that “we’re going to deliver price stability” and that “the tactics, the strategy and the rest, that’s still to come”. Our latest FX forecasts (click here) released yesterday are based on the assumption that the Fed will not raise rates. If we are wrong the US dollar could strengthen further by 3-5%.

Today’s nonfarm payrolls report for June will be important in assessing the prospect of Fed rate hikes this year. Employment growth has rebounded robustly over the last three months by an average of 188k/month although it did follow a six-month period of flat employment growth. Today’s report is expected to reveal some moderation in employment growth back towards 110k in June. Yesterday’s ADP survey estimated private sector job gains of just under 100k. Market participants will also be closely watching the unemployment rate. It has held steady at 4.3% in recent months which has provided some reassurance to the Fed that the labour market is not tightening significantly and therefore requires rate hikes. to reinforce the US dollar’s current upward momentum another robust employment increase and/or drop in the unemployment rate will be needed. The proximity of the US holiday tomorrow is also making market participants nervous over the risk of Japan intervening in the FX market to support that yen. Those fears have been heightened by a Reuters report stating that Japan will shift to surprise yen intervention tactics. According to the report citing unidentified people, Japan’s MoF could step in abruptly to wipe out speculative yen positions. Leveraged funds have significantly increased short yen positions since the last bout of intervention in late April/early May.                   

EUR IS GIVING BACK STRONG GAINS FROM LAST YEAR

Source: Bloomberg, Macrobond & MUFG Research