G10 FX Weekly: EUR to Benefit From Softer Eurozone Inflation and a Vigilant ECB

Summary

• Eurozone (EZ) CPI readings, both headline and core, are coming in softer, with the most recent data below consensus estimates.
• With inflation dragging less on the EZ economy and the European Central Bank (ECB) committed to containing higher prices, expect a stronger euro.

Market Implications

• Bullish EUR. Expect the Deutsche Bank EUR trade-weighted index (TWI) to make a new year-to-date (YTD) high above 124.
• Bullish EUR/USD. After pulling back last month from its intraday YTD high near 1.11, the pair should trade back to that level in 2H 2023.
• Bullish EUR/GBP. The pair has traded in a relatively tight ~0.8560/0.8980 range so far this year. In the coming months, expect the euro to revisit the YTD high near 0.9000.

Introduction

Seven ECB hikes this cycle have taken the Deposit Rate from -0.5% to 3.25%, but at last Eurozone inflation is moderating. Headline CPI has now fallen in five of the past seven months, dropping from the peak at 10.7% last October to 6.1% last month.

Core CPI, which strips out food and energy, has also started to slow. After topping out in March at 5.7%, the reading has moderated over the past two months – the most recent print was 5.3%.

That inflation appears to be heading in the right direction will provide comfort to the ECB Governing Council (GC). Nonetheless, recent messaging from GC members has highlighted the ongoing concern from policymakers about inflation. And the market is pricing another ~50 basis points (bp) of tightening in 2023, beginning with a 25bp hike next week.

This combination of lower inflation and a still vigilant central bank will support the euro. We expect EUR/USD and EUR/GBP to grind steadily higher in the second half of 2023, leading to a stronger EUR TWI as well.

EUR So Far This Year

The Deutsche Bank EUR TWI is little changed this year, having traded in a ~3.5% range YTD. So far this year, the euro is the fourth strongest of the G10 currencies against the US dollar.

In the developed market currency space in 2023, only the British pound, Swiss franc and Canadian dollar have outperformed the euro – and only modestly.

For the rest of the G10, the euro has performed best against the Norwegian krone (EUR/NOK is up ~11.3% in 2023), the Japanese yen (EUR/JPY is up ~6.2%) and the New Zealand dollar (EUR/NZD is up ~4.9%).

ECB Messaging Remains Cautious on Inflation Outlook

Despite the improving inflation numbers, ECB messaging remains cautious, with several speakers this week reiterating concerns about Eurozone prices.

Instead of highlighting slowing EZ inflation, the central bankers remain hawkish. They say the ECB will need to tighten policy more to return inflation to the central bank’s 2% target.

ECB President Christine Lagarde said this week that inflation risks remain powerful and that higher rates will be needed to fight those risks. Lagarde added that there is yet no clear evidence that underlying inflation has peaked, citing elevated food prices.

With the ECB meeting on 15 June, Lagarde is clearly setting the stage for a rate hike. The market fully expects this, with ~25bp of tightening already priced. Lagarde’s language has reiterated messaging from her colleagues on the GC, with Gabriel Makhlouf saying that the ECB is likely to raise rates at both its June and July meetings.

Additionally, Bundesbank President Joachim Nagel said on Monday that ‘as things stand, several interest-rate steps are still needed …. In my view, it’s by no means certain that interest rates will peak as early as this summer.’

We expect the ECB to validate market expectations and hike at its next two meetings. This should be broadly supportive of the EUR TWI, also nudging both EUR/USD and EUR/GBP higher.

A Look at Two EUR Pairs

EUR/USD and EUR/GBP comprise roughly two-thirds of the EUR TWI. Given the strong weightings of both currency pairs, we look at them in greater detail.

EUR/USD

After falling ~1.8% in the first few months of 2023, EUR/USD gained ~5.5% between the low in mid-March to the YTD high on 26 April. The pair is now little changed on the year, currently trading on a 1.07 handle.

We wrote in depth about EUR/USD back in February, taking a cautiously bullish view. We expected the euro to trade in a ~1.05/1.10 range. Our bias was to fade any euro weakness, with a view to EUR/USD trading to the top end of the range.

The approach worked well in the few months that followed, with EUR/USD eventually trading at ~1.11 in late April, the current YTD high.

We view the pullback since then not as a massive change in trend, but more a consolidation of the previously bullish price action and a shaking out of weak longs initiated at sub-optimal levels.

As outlined above, the combination of slowing inflation and a resolute ECB will support the euro, and this will lift EUR/USD.

The US Federal Reserve (Fed) has also enjoyed slowing inflation readings. So like the ECB, it is in a favourable position compared with the Bank of England (BoE), which faces the prospect of stagflation (more on this below).

We expect EUR/USD to trade back to the YTD high in the coming months. Markets price another ~50bp of ECB tightening and the Fed as nearer the end of its tightening cycle. Interest rate differentials, therefore, should favour EUR/USD at the margin.

EUR/GBP

EUR/GBP has traded in a relatively narrow ~0.8560/0.8980 range YTD, with both the pound and euro near the top of the G10 league table.

We have outlined how improving inflation dynamics in the Eurozone and a nonetheless aggressive ECB improve the euro’s prospects.

This contrasts the Bank of England (BoE) scenario, where policymakers are wrestling with persistently high (and still rising core) inflation, even after a concerted hiking cycle. We recently argued that this is undermining the BoE’s credibility and that the UK is in danger of suffering stagflation. We think this would weigh on the pound.

By contrast, the ECB’s relative success against inflation should be a net positive for the euro, leading to upside for the currency in H2 2023.

If the economic fundamentals in the UK deteriorate in H2 as we expect, the euro should modestly outperform sterling. EUR/GBP should trade back toward the top of this year’s range.

In recent weeks, as markets have ratcheted their BoE rate expectations higher, price action in EUR/GBP has been choppy, with the knee-jerk reaction being a strong GBP. Nonetheless, in the medium to longer term, the contrasting economic fortunes in the EZ and UK will lead EUR/GBP higher.

Global Recession Will Be Especially Bad for GBP

The probability of a US-led global recession remains elevated, with Macro Hive’s US recession model forecasting a 90% probability of a recession in the next 12 months. The Fed’s model has that probability at 70%.

A recession could materially impact our bullish euro call. A potential threat to a stronger euro would be overtightening by the ECB, which would worsen any EZ recession.

An underperforming EZ economy would hinder the currency. The ECB’s singular focus (its mandate to keep inflation at or near 2%) could worsen the euro’s prospects.

That said, market expectations for current ECB policy show that most of the tightening has already occurred, and any further tightening should be modest. That could well be the case should headline and core inflation keep trending down.

We probably cannot say the same for the UK. Sticky, too-high inflation has the potential to be an ongoing, persistent problem. This will likely force the BoE to hike rates into a recession.

So, although EUR/USD upside is murkier in the global recession scenario, we think the euro will outperform the pound. Stagflation in the UK would be very detrimental to the currency, especially in a recession.

Conclusion

The combination of already receding EZ inflation readings and a steadfastly aggressive ECB will be a net positive for the euro. As such, we expect the EUR TWI, EUR/USD and EUR/GBP to reverse recent weakness and return to YTD highs in the coming months.

Richard Jones is a Macro Strategist for VDK Capital, a London-based venture capital firm. He has traded and invested in interest rate and FX market portfolios spanning three decades, both on the buy-side and sell-side. 

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(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)