Euro Advances on Bumper Inflation Data Reading

- Euro rises in risk-on trading and as inflation turns higher.

- Eurozone CPI rises to 1.9% and core CPI hits 1.1% in May.

- But, scope for more Euro gains is limited due to Italian politics.

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The Euro rose solidly against its developed world rivals Thursday as markets returned a steady bid for so called risk assets and traders responded to the latest Eurozone inflation data, which showed continental price pressures rebounding out of an earlier trough during the month of May.

Headline Eurozone inflation rose at a rate of 1.9% during May, up from 1.2% during April and far ahead of the consensus for a reading of 1.6%, the best offering the Euro a steady bid. A rise in prices of energy, food, alcohol and tobacco contributed the lion's share of the increase in the headline number although non-energy industrial goods and services price inflation also picked up notably.

The numbers helped the Euro-Dollar exchange rate to rise back above 1.17, having been as low as 1.1544 earlier in the week. The Pound-to-Euro exchange rate was quoted at 1.1399, with Sterling off its May's best of 1.1495 earlier this week.

The more important measure of core inflation, which removes volatile commodity items like energy from the goods basket and so is seen as a more accurate representation of domestically generated inflation pressures, rose by 1.1% when markets had been looking for a 1% increase. This is up from 0.7% for the month of April.

However, there are some concerns about the drivers of the boost to the core component, which might quel enthusiasm for the single-currency to some degree.

"The rise in core inflation may have partly reflected the timing of bank holidays in May, which appear to have boosted services prices in Germany in particular. But it is presumably also due to the region’s improving labour market," says Stephen Brown, an economist at Capital Economics.

"We expect the increase to be led by volatile components such as package holidays and air fares as Easter-related distortions correct," says Fabio Fois, an economist with Barclays, concerning the core inflation number.

May's inflation numbers are doubly-important for the Euro not only because inflation had fallen for the last two consecutive months but also because the recent market turmoil over Italian politics was seen placing a question mark over the outlook for European Central Bank (ECB) monetary policy.

Markets care about the inflation numbers because it is changes to consumer price pressures that the ECB is attempting to manipulate when it makes tweaks to its monetary policies.

The central bank needs to see Eurozone consumer price growth make a sustainable return toward the 2% target before it can fully wind down its quantitative easing programme and begin to contemplate an interest rate rise; and it is the promise of an interest rate rise that had markets bidding the Euro in 2017. When expectations for that interest rate rise are pushed further into the future it is bad for the Euro.

"We are sticking to our view that core inflation will reach 1.3%-to-1.4% at the end of the year, but we are now on notice with respect to the trend in goods inflation. For now though, the sharp increase in the headline should be enough to help the ECB over the line with respect to ending QE later this year," says Claus Vistesen, chief Eurozone economist at Pantheon Macroeconomics.

The Euro itself needs the European Central Bank to move forward with efforts to normalise Eurozone monetary policy if it is to recover ground lost to the Dollar and other currencies during recent weeks, particularly as financial markets have renewed their appreciation for interest rate differentials and rate are rising elsewhere in the developed world. But Barclays have told clients they do not expect core inflation to accelerate decisively from here.

"We believe that the likely May rebound in core inflation should not be seen as an indication of mounting pipeline pressures. Core services prices, albeit showing some tentative signs of recovery, remain pegged to the ongoing modest recovery in business services; meanwhile, along the goods prices chain, inflationary sources have moved from currency movements to producer prices," says Fois.

Consistent with this, Barclays says underlying inflation will remain subdued, averaging 1.2% and 1.4% in 2018 and 2019. Capital Economics' Brown is more optimistic on the trajectory for core inflation, saying:

"With wage growth gradually rising, we suspect that core inflation will drift higher this year. Moreover, recent rises in oil prices will keep headline inflation above 2% in the coming months. The drama in Italy creates something of a headache for the ECB. But provided that the situation remains contained, we doubt that it will prevent the ECB from bringing its QE programme to an end this year."

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Euro Supported as Italian Political Situation Settles

Thursday's data comes hard on the heels of fresh upset in Italian politics, with both Five Star Movement and League parties having nominated avowed Eurosceptic Paolo Savona to the position of Italian finance minister during talks over the formation of a coalition government.

"Following the turmoil on Tuesday, there was a sharp narrowing of yield spreads in Italian bond markets yesterday which has continued into today’s trading. Strong demand at the BTP auction yesterday helped but key was the step back from immediate elections and the attempt by President Mattarella, Five Star and The League to form a government," says Derek Halpenny, European head of global markets research at MUFG.

Savona's appointment was vetoed by Italian President Sergio Mattarella who subsequently nominated former International Monetary Fund official Carlo Cottarelli to lead a caretaker government, which stoked fears of another election and an even stronger mandate for anti-establishment parties of the left and right whose only common ground is a dislike of the Euro and European Union fiscal rules.

"If this period of turmoil does subside, market participants will be watching closely to see whether the week of turmoil may change to some degree the fiscal plans of the coalition. But, we may now have a period of calm while investors await the latest attempt of the forming of a government and gauge the future policy path," Halpenny adds. "The scope for further euro gains will likely be limited for now."

Reports from Il Corriere della Sera, La Repubblica, Ansa and Il Sole 24 Ore claimed Wednesday that League and the Five Start Movement (M5S) are in talks to agree a new government, but that both parties could also back a so called caretaker government if the discussions fail - so long as fresh elections are held by September or October. A third option is a separate coalition led by the centre right but that also features parties from across the political spectrum.

Austerity is at the heart of Italy's developing political crisis. Years of fiscal largesse, a brutal economic crisis and European Union budget rules have seen deep and far reaching austerity measures imposed on Italy, mostly by technocratic caretaker governments of the past, but also by the previous Democratic Party regime led by Matteo Renzi.

Both M5S and League have pledged to roll back many of these austerity measures, particularly reforms to the pension system, placing them on a collision course with Brussels budget hawks who have the power to reject the Italian government's spending plans. M5S and League have historically opposed the Euro so economists are mindful of a possible nightmare scenario in which conflict over public spending leads to an Italian referendum on the single currency.

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