Euro-Dollar Potentially Biggest Mover on U.S. Inflation Undershoot

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The Euro to Dollar exchange rate looks to build on this week's recovery but will need U.S. inflation to undershoot in order to advance above 1.10.

Euro-Dollar trades at 1.0968 at the time of writing, helped by a broader pullback in the U.S. Dollar that comes in sympathy with an optimistic tone on global equity markets.

"Improved risk appetite weighed on the USD," says Joseph Capurso, a foreign exchange market strategist with Commonwealth Bank.

Capurso says the Euro-Dollar could be one of the bigger winners in global FX if U.S. inflation undershoots expectations.

"Financial markets have been very sensitive to even small misses in the CPI in recent months," he explains in a daily note.

"For example, the 0.1pp miss in the October core CPI caused the USD to slump by 1.5% and US Treasury yields to fall by around 20bp across the curve," he adds.

Consensus looks for core CPI inflation to have increased by a strong 0.3% month-on-month in December, but Commonwealth Bank considers the risk of a below‑consensus outcome for the core CPI as greater than the risk of an above‑consensus outcome.

"Therefore, the USD could ease further today; a fall of 1% or more is possible. As the major alternative to the USD, we expect EUR to be the largest winner from possible USD weakness," says Capurso.

Analysts at private swiss bank J. Safra Sarasin meanwhile caution that the Euro's near-term strength is unlikely to sustain.

"The euro has rallied on the back of a compression of the dollar-euro yield differential. Yet we think the recent move looks a bit overdone as the euro area continues to be in a weak cyclical position," says Claudio Wewel, FX Strategist at J. Safra Sarasin.

Wewel expects Euro-Dollar to return above 1.10 by the fourth quarter of the year when the global economic recovery gathers traction.

"Euro support should improve as we expect a moderate recovery of private consumption in the euro area. The stabilisation of Chinese growth should further support the euro, given the high exposure of the euro area manufacturing sector to China," he says.