Receding Core Inflation Could Soon Pose Risk to the Euro Says BCA Research

"Consequently, near-term interest rate differentials should soon start to trade against the euro" - BCA Research.

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European inflation is in retreat and the core inflation rate is on the cusp of a protracted retrenchment that would invite financial markets to position for an eventual series of European Central Bank (ECB) interest rate cuts and which could take the wind from the sails of the Euro, according to BCA Research.

Core inflation ticked higher from 5.6% to 5.7% in March even as overall inflation was recorded as having fallen for a fifth consecutive month but some observers say this was likely just a temporary setback and that both measures of consumer price growth should decline convincingly in the months ahead.

"The March number is likely to be the peak in Eurozone core CPI. By the end of the summer, Eurozone underlying inflation will have slowed enough to alleviate the fears at the ECB," says Mathieu Savary, chief European strategist at BCA Research.

"Even after the recent rebound in oil prices following OPEC’s output cut, the persistent weakness in European natural gas prices suggests that energy CPI will continue to depress headline inflation over the coming months," Savary and colleagues write in a research briefing last week.

Source: BCA Research.

Recent declines in energy prices are a heavy weight around the ankles of inflation but are not alone in their dampening influence on price pressures as some of the most recent surveys suggest that falling manufacturing input and output prices can also be expected reduce inflation up ahead.

These developments have left the services sector as almost the sole remaining upward influence on inflation in Europe during recent months but Savary and the BCA team say this source of price pressures is likely to eventually be undermined by the effects of European Central Bank interest rate policy. 

"The housing market confirms that inflationary forces are ebbing at the core level. House prices have begun to decline across the EU," Savary says.

"In a context in which wage growth looks set to peak, house prices are declining, and price expectations are downshifting, the emergence of a European wage-price spiral seems unlikely. As a result, we continue to heed the message from energy CPI," he adds. 

Source: BCA Research.

ECB interest rate policy is set to reduce household consumption and constrain, if not reduce outright the prices of some goods and services in the Euro Area over the coming months, and will be bolstered as a disinflationary force by the recent declines in energy prices.

Savary and colleagues cite the time it took for last year's increases in energy prices to show up in various inflation measures for thinking that it's likely to take six months or so for the recent declines to be fully reflected in Europe's core inflation rate, which is the measure most closely watched by the ECB.

"The dynamics in energy prices and global supply chain suggest that headline inflationary pressures are ebbing. So do the internal developments within the PMI survey. Core CPI will soon begin to weaken as the ECB’s tight monetary setting will weigh on wages," Savary and colleagues say.

"Moreover, if European inflation follows the path we foresee, the need for more hawkishness from the ECB than from the Fed dissipates. Consequently, near-term interest rate differentials should soon start to trade against the euro," they add. 

Above: Euro to Dollar rate shown at daily intervals with spread or gap between 02-year German and U.S. bond yields. Click image for closer inspection.

The BCA team says the likely retreat of core inflation is a risk to the Euro because it would likely compel financial markets to price-in a series of interest rate cuts being announced by the ECB sometime next year, bringing the assumed path for European interest rates closer into line with that of the U.S.

Prices in interest rate derivative markets have shifted to imply increasingly over the recent months that investors expect the Federal Reserve to cut its interest rate multiple times next year, which has weighed on the U.S. Dollar and helped lift the Euro in the process.

Hence the risk of a setback for the Euro to Dollar rate if inflation figures out this Friday, or over subsequent months, does have the anticipated effect on the market.

"Investors foresee less than one rate cut from the ECB by June 2024, but they expect 175bps of cuts by the Fed (see next chart). This pricing is odd because the ECB will cut rates if the global economy enters a recession led by the US, as the US OIS curve currently anticipates," Savary says.

"Meanwhile, if the global economy avoids a recession, as the €STR curve implies, the Fed will not cut interest rates as much," he adds.

Source: BCA Research.