Euro Overbought? EUR Should be Higher on Strong Inflation Data, Concerns Grow of Looming Correction Against Pound and Dollar

• EUR to GBP conversion: 0.8944
• EUR to USD conversion: 1.1728

The Euro is seen near multi-month highs against the US Dollar and Pound Sterling at the start of the new week as a key data release confirms Eurozone inflation is rising.

However we note that the currency's reaction to the data is not as strong as many had been expecting, which suggests perhaps the move is now over-baked and the Euro is increasingly at risk of a downside correction.

Eurozone inflation data from Eurostat revealed a 1.3% annualised rise in July, similar to the previous month. This is the figure markets were expecting.

However, core inflation rose 1.2%; faster than the 1.1% seen previously and this suggests underlying wage pressures and economic activity are heading higher.

This is arguably the more important number to be watching from a currency perspective.

This data be welcomed by the European Central Bank which has slashed interest rates to record lows and pumped billions of Euros into the economy via its quantitative easing programme.

Markets are now betting the ECB can now withdraw their support and this is fuelling a stronger Euro.

Upside surprise as Eurozone core CPI increases to +1.3% (+1.1% exp, +1.2% last) which is helping to pull #EURUSD 15 pips higher.#Forex

— Richard Perry (@HantecRich) July 31, 2017

“Given still-flat positioning, the weak USD and the focus of FX investors on the timing of the ECB’s QE taper, we would expect a bigger move in the EUR in the event of a hotter than-expected core reading. A reading of 1.2% YoY or more in core inflation could cause a breach of resistance at 1.1800 in EURUSD,” says Greg Anderson, an analyst with BMO Capital Markets.

The Euro ended the previous week on a positive note following the release of inflation data for individual Eurozone countries which also suggested inflation is picking up, particularly in Germany.

Looking ahead data-wise, keep an eye on German employment data due on Tuesday, August 1.

“Last week’s hotter-than-expected German inflation data have also elevated the importance of Tuesday’s employment data, where an unexpected drop in the unemployment rate to 5.6% or less in July will probably prove EUR-supportive,” says Anderson.

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Beware Shallow Correction Lower in the Euro

The Euro has had a solid run of late and this has got many in the foreign exchange community concerned that an inevitable correction beckons.

"Today's data, all else equal, should have motivated a larger response in rates, which  could have fed back into a stronger EUR. It didn't. While month-end and summertime trading conditions are likely to have a strong influence today, we can't escape the feeling that this market is very long EURs here," says Jacqui Douglas, Chief European Macro Strategist with TD Securities in London.

Analyst Jane Foley at Rabobank suggests that the gains in the Euro were probably limited by the simple fact core inflation at 1.2% is still far away from the ECB's 2% target - more work must be done by the economy on the inflation front in order to really get the Euro pressuring fresh highs.

Foley also believes many in the market will be wary that the ECB would look to limit the Euro's recent strength.

"Central banks rarely welcome  volatility in the FX market and the ECB will be keen for the rapid movement  in EUR/USD to abate," says Foley.

Indeed, many will now be positioned for a retracement.

BMO Capital say they are looking for near-term selling opportunities in the 1.1800/50 range ahead of Friday’s US employment data.

“We think EURUSD is vulnerable to a downside correction at some point because it is trading well above the levels implied by short-term swap rate differentials,” says Anderson.

However, he expects any weakness in EUR/USD to encounter very firm support in the 1.1620/1.1650 range throughout the week.

Euro v Pound Exchange Rate: Sterling Strength Possible as Bank of England Looks to Avoid GBP Weakness

The Bank of England’s rate decision and Quarterly Inflation Report on Thursday are the highlights of the UK event calendar and represents the key driver of Sterling.

Markets are of the view that an interest rate hike this week as a very low probability outcome following the tepid June retail sales report and the June deceleration in core inflation.

“However, we expect elements of the rate decision and Inflation Report to contain hawkish tilts, thereby providing some support to the GBP. The GBP will be an important element of the discussions within the MPC because fluctuations in the value of the currency have an impact on real income growth,” says Anderson.

With other major central banks normalising their own policy stances, BMO Capital suggest  the Bank of England would want to avoid sending an overtly dovish signal this week in order to avoid extended GBP weakness.

As a result, BMO Capital expect a repeat of the 5-3 vote from the June rate decision, with 3 MPC officials voting in favour of a rate hike and former MPC member Forbes’ rate hike vote replaced with Andy Haldane’s (the fact that the MPC has one remaining vacancy until early-September precludes a 6-3 vote).

“EURGBP will be watched closely due to its close proximity with the 0.9000 mark. We think leveraged money investors are moderately net-long of EURGBP, so if the MPC goes as we expect, the pair could fade below 0.8900 to 0.8850,” says Anderson.

EUR/GBP at 0.90 equals 1.11 in Pound to Euro terms while 0.89 equates to 1.1236 and 0.8850 equates to 1.1299.

So these are some upside targets those watching this exchange rate could be focusing on this coming week.

“We also note that the EURUSD rally seems to have triggered recent EURGBP gains rather than UK economic fundamentals as reflected by short-term swap rate differentials,” says Anderson hinting at the importance that the headline EUR/USD continues to exert.

As a result we will be watching moves in EUR/USD closely for further hints if direction in EUR/GBP.