EURUSD Under Pressure After German Inflation Points to Increased ECB Optionality

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Euro exchange rates were under pressure after the release of a raft of softer-than-expected data releases from the Eurozone that suggested the pressure to hike interest rates at the European Central Bank (ECB) was easing.

German state inflation readings started to dribble in from 06:30 BST when the state of North Rhine Westphalia - a key economic region - revealed inflation was at 0.1% month-on-month in May, a significant undershoot of the 0.5% expected by markets and a marked slowdown on April's 0.4% reading.

The data signalled the all-state reading - due later in the day - was set to undershoot, meaning the Eurozone's inflation problem might be fading.

When it came, German CPI inflation was reported to have fallen 0.1% in the month to May, a sharp undershoot of the 0.6% gain the market was looking for and a rapid deceleration on April's 0.4% gain. In the year to May prices rose 6.1%, undershooting the expected 7.3% and April's 7.2%.

"The worst is over," says Salomon Fiedler, an economist at Berenberg Bank. "Consumer price inflation is set to decrease further in the quarters ahead on the back of receding cost pressures that have already been visible for some time in early stages of the pricing chain."

For the Euro, this means the ECB has more optionality than previously expected when it comes to raising interest rates again.

This weighed on Eurozone sovereign bond yields, prompting a further retracement in Euro exchange rates. The Euro to Dollar exchange rate (EUR/USD) retreated 0.60% on the day to 1.0671 as it extended a month-long retreat.

Above: EURUSD at daily intervals.

The contrast in inflation dynamics between the Eurozone and UK is now particularly notable; UK CPI data for April revealed inflation overshot expectations, prompting investors to raise bets that the Bank of England will continue to hike rates on a number of occasions over the coming months.

This means UK bond yields are seeing their premium to Eurozone yields widen, driving up the value of the Pound relative to the Euro.

French CPI followed those of German North Rhine Westphalia in providing another welcome surprise: the headline read at -0.1% month-on-month in May, undershooting expectations for 0.4% and representing a sharp contraction on the previous month's 0.6%.

More German CPI figures hit the screens midmorning and the message was similar to that coming from the North Rhine: Brandenburg reported 0.1% m/m in May, below 0.4% expected, Bavaria reported -0.1% vs. 0.4% expected and Hesse reported 0% vs. 0.3% expected. Saxony reported -0.3% vs. 0.3% expected.

The all-German figure was therefore expected to undershoot well ahead of its release, a pleasing development for the people of Europe and policymakers in Frankfurt.

However, for Euro bulls, this development could spell a bout of underperformance.

Looking ahead, economists at ING say it could be too soon to declare victory in the fight against inflation and that it will take until the end of the year for headline inflation to fall into the 3%-4% range.

"Beyond that statistical noise, the German and European inflation outlook is highly affected by two opposing drivers. Lower-than-expected energy prices due to the warm winter weather are likely to push down headline inflation faster than recent forecasts suggest. On the other hand, recent wage settlements and still decent pipeline pressure in services are likely to keep core inflation high. We continue to expect that German headline inflation will average around 6% this year," says Carsten Brzeski, Global Head of Macro at ING Bank.

The consensus of economists expects another 25 basis point interest rate hike from the ECB in June.

"While inflation is definitely moving in the right direction, it is still much higher than would be consistent with the ECB’s inflation target. We thus expect the ECB to still go ahead with two more rate hikes by 25bp each in June and July before staying put," says Berenberg's Fiedler.