Strong Inflation Data Puts a Floor Under EUR/USD but Strategists Look for Further Declines

© European Central Bank 

- Surprisingly strong inflation data raises eyebrows

- "Easter effect" cited as being behind phenomenon

- ANZ, ING, Commerzbank look for lower EUR as Soc Gen says buy.

Surprisingly strong inflation data out of the Eurozone helped support the Euro ahead of the weekend, but the market's response to the data was capped by the observation that the improved price data could merely be a seasonal quirk.

Inflation rocketed to 1.7% in April, from 1.4% previously, when markets were looking for only 1.6%. Core inflation, which ignores commoditised food and energy items so is thought to provide a better reflection of domestically generated price pressures, rose from 0.8% to 1.2%. 

The data would suggest the European Central Bank's long-winded attempt to reflate the Eurozone economy is finally working, which should in turn herald Euro-supportive interest rate rises on the horizon.

However, as always in financial markets, it is the details that matter.

"Eye-catching headlines, but nothing that markets weren’t prepared for given this week’s advance data from the major EZ economies. The leap in the core rate is startling, but it’s heavily distorted by the Easter effect," says Claus Vistesen, chief Eurozone economist at Pantheon Macroeconomics. "This kind of volatility is normal around shifts in the timing of Easter, but the effect has increased in Germany this year given the change in the methodology of the package holiday CPI that was implemented in January."

Vistesen identifies package holidays and airfares as the most likely culprits behind the Easter surge in inflation, but warns that the underlying trend in continental price pressures remains weak, suggesting the upward move seen in April may well be partially reversed in subsequent months.

Pantheon forecasts the Eurozone core inflation rate will rise as high as 1.3% in the next 12 months however, this would still leave the truer measure of domestic inflation pressures a long way off from the European Central Bank target of "close to but below 2%."

Above: Contributions to Eurozone inflation rates. Source: Eurostat.

"We expect core inflation to fall back to about 1.0% in May, and remain broadly unchanged over the next couple of years. And as energy inflation declines we expect the headline rate to fall below 1.0% towards the end of this year. As a result, we think the ECB will have to loosen policy before long, probably starting by strengthening its forward guidance on interest rates," says Christina Iacovides of Capital Economics. 

Markets care about the inflation data because it has significant influence over ECB interest rate policy, which is the raison d'être for most moves in Euro exchange rates.

Central banks tend to raise interest rates when inflation is heating up, as higher interest rates tend to cool the economy and help perform a stabilising act.

The side effect of higher rates is meanwhile a stronger Euro as capital tends to flow to areas where returns are expected to be higher in the future.

Thus, higher inflation = good for the Euro, and on paper today's data should be supportive.

But, the consensus is that it will take more strong readings before the dial on ECB expectations really starts to shift.

"The ECB is unlikely to bat an eyelid towards March and April fluctuations, but may still be confused by the recent signals about growth and inflation. The Q1 growth figures were surprisingly strong, but recent surveys indicate new orders continue to come in weak," says Bert Colijn, an economist at ING Group. "With selling price expectations falling, the ECB won't be too optimistic in how the pick up in growth in Q1 will translate into price growth."

Above: Euro-to-Dollar rate shown at daily intervals.

"We are long EUR/USD with a 1.16 target, but stop losses need to be set tightly. A move towards or below 1.10 is still unlikely in our view, but long euro investors should care. The list of ‘what if' developments that could derail the bullish central case merits consideration," says Kit Juckes, chief FX strategist at Societe Generale. "History is not bound to repeat itself, but EUR/USD nonetheless has fallen in May in eight of the past ten years."

The Euro-to-Dollar rate reversed an earlier 0.01% gain to trade -0.17% lower at 1.1154 following the release Friday and is now down -2.7% for 2019. 

Juckes is looking for a steep recovery in EUR/USD over the coming weeks and months, but both Nordea Markets and Westpac have already been 'stopped-out' of very similar trades in recent weeks. And technical analysts are warning of more losses to come for the Euro.

“EUR/USD has held over the 1.1110, the May 2017 low but seems to be losing upside momentum just ahead of the 55 day ma at 1.1274 and the market may need to consolidate further, intraday Elliott wave counts are contradictory. For now, we are unable to rule out a retest of the 1.1110 support,” says Karen Jones, head of technical analysis at Commerzbank.

Above: Euro-to-Dollar rate shown at weekly intervals.

Eurozone inflation has been stuck below the ECB’s 2% target ever since November 2018 when oil prices began reversing earlier gains. If not for volatility in oil prices, the headline rate might not have seen the target level for a number of years.

Core inflation, which is seen as the truer measure of price pressures, has not been above 1.3% at all in the four years since the European Central Bank began its now-shuttered quantitative easing programme in an effort to lift growth and inflation.

“The overall picture of bleak core inflation remains. Next month will likely see some overshooting of 1% due to the Easter effect reversing, but the underlying story remains one of subdued core inflation as businesses continue to take higher wage growth in their margins because of global uncertainty,” says Bert Colijn, an economist at ING Group.

The Euro has suffered in 2019 due to a faltering economy that's been trailing behind its U.S rival ever since early last year when the U.S. economy was juiced by once-in-a-generation tax reforms and growth on the old continent was soon to be crimped by a slowing Chinese behemoth that was wounded in a tariff fight with the U.S.

Last year's ongoing slowdown put a torpedo through the consensus idea that a recovering economy would soon allow the European Central Bank to do away with its crisis-era monetary policy around the same time the Federal Reserve rate hiking cycle was maturing. That was supposed to turn the global tide of capital flows in favour of the Euro rather than a high-yielding U.S. Dollar.

“EA inflation remains stubbornly low. The rebound in Q1 GDP growth is welcome, but it barely returned the economy to trend and is insufficient to exert upward pressure on inflation. The EA has a growth and inflation deficit to the US, which skews inflation, policy settings and expected returns in the US’s favour. We expect that will show in modest USD outperformance vs EUR in coming months,” says Daniel Been, head of FX strategy at ANZ.

Now, fearing for the economic and inflation outlook, the ECB has told markets that its interest rates will remain at their current record lows until “at least through the end of 2019” when previously markets had hoped for a rate hike some time in Autumn.

This dire outlook that entrenches the ECB’s base rate at the 0% level, while the Federal Reserve’s interest rate sits at 2.5%, helped force the Euro-to-Dollar rate to 22-month low last week.

Above: GDP growth correlation with PMI surveys and sentiment (left). Source: Societe Generale.

"Our economists expect the flow of eurozone macroeconomic news to improve, while market sentiment remains bearish on the euro growth outlook, probably overly influenced by the weakness of PMI surveys and the German industrial sector. EUR/USD is now determined much more by growth expectations than anything else, so additional PMI softness would weight further on the single currency," Juckes writes, in a note to clients Friday.

Eurozone GDP growth came in at 0.4% for the opening quarter, up from 0.2% previously and ahead of the consensus for growth of only 0.3%. This ensured the annualised rate of economic growth held steady at 1.2% when it had been expected to decline.

The data followed a March upturn in the Chinese industrial sector that led some economists to anticipate that a European recovery could soon follow along behind it.

However, a detailed breakdown of the different contributions to GDP growth will not be available until late in May, which means the jury is still out on whether the boost was entirely a domestic phenomenon or something more than that.

The answer to the above question matters greatly for determining the trajectory and timing of changes in interest rates on both sides of the Atlantic, particularly as U.S. GDP data for the first quarter was far stronger than many economists had dared to imagine.

"The recent fall below 1.12 has prompted quite a few analysts to cut their EUR/USD forecasts. We had already penned a move to 1.10 in our profile for 2Q19, but, like others, acknowledge that the case for a rebound later this year has become a little harder," says Chris Turner, head of FX strategy at ING Group. "We still think EUR/USD will put in a significant low this year."

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