Decline in Eurozone inflation not a bearish signal for EUR in the medium term
Following the ongoing-robust readings in a wide array of indicators (PMIs, IFO) market focus next week will shift to the preliminary Eurozone CPI numbers for May. As discussed by our economists, we expect the headline rate to retreat back to 1.5% yoy and core to 0.9% yoy. Will such a decline trigger euro weakness, at least a meaningful and sustainable way? We do not think so.
First, the rise in German yields (and EUR/USD) has not been driven by the one-off spike in April core CPI but rather by the broad-based and sustained recovery in euro area growth and the rising trend in inflation, which is surely a reflection of the market’s assessment that the region’s output gap is closing at a faster clip than initially expected. To the extent that the core reading comes roughly in line with our expectations, this should not be perceived as a change in price-growth dynamics (the trend will likely remain unchanged) and should not lead investors to price-in a more-dovish ECB.
Second, one thing that many investors seem to have forgotten is that higher inflation compresses real rates of return and erodes the value of the exchange rate. To a certain extent (and understandably), low inflation numbers over the past few years have driven many investors to position for currency weakness due to excessively loose monetary policies – a response to deflation fears. However, as deflation risks have vanished (something also acknowledged by ECB executive board member Peter Praet in his recent speech in Sofia), the importance of real rate developments should increase. In fact, a reversion closer to trend of core price dynamics should actually boost real yields in the Eurozone. Consequently, we see no reason to turn bearish on the EUR in the long term. However, we some profit taking on recent EUR/USD is likely in the near term.
Source: GrowthAces.com - your daily trading strategies newsletter