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How Is Reflation Affecting The Euro?



One of the key terms already dominating the news flow this year is reflation. Price action this week has provided a key insight into how FX markets trade during the time of reflation. Soaring global PMIs, surging industrial commodities plus stronger German and EuroZone inflation have all combined to undermine EUR which has been weighed on over the first trading day of the year.
Currency Not Responding To Better Inflation Data

A weakening currency during times of rising inflation reflects the level of skepticism in the market regarding the central bank’s credibility. When central banks are deemed Hawkish, then positive inflation readings tend to immediately push FX prices higher, fuelled by increasingly supportive nominal interest rate differentials. However, when the central bank is deemed Dovish, then it is not the nominal interest rate differentials that determine the market response but instead the real interest rate differentials. Indeed, Wednesday’s rally in the EURUSD can be viewed more as a function of the Dollar weakening ahead of the FOMC minutes, rather than a rally on positive inflation data.

Inflation data released on Wednesday showed that core inflation rose to 0.9% in December, above estimates of 0.8% whilst headline inflation rose to 1.1% over the same periods, above estimates of 1%.



Dovish ECB Framework

The ECB has clearly established a Dovish framework, and in the context of EMU divergence pressures increasing, they have little choice other than to apply a policy for the weakest relevant link. Put simply, a booming Germany with inflation rising quickly against the ECB’s target of 2% doesn’t in fact support a higher EUR rate. In fact, the combination of rising inflation and a Dovish ECB framework is weighing on real rates, especially the short end of the curve which translates directly into EUR selling pressure.

EUR Trading Like JPY

EUR is currently trading in a similar fashion to how JPY did last autumn. The BOJ had established their Dovish framework by announcing their intention to manage the yield curve. During a period of global reflation, this essentially equaled a call for lower real rates and yields. Indeed, since the September BOJ meeting, JPY real yields have fallen the most within the G10 space, forcing JPY lower.

Reflation Grants ECB Options

Currently, the ECB has not engaged in any yield curve management, but its communications do not suggest an early tightening response to rising inflation. Whilst the BOJ was able to push the JPY Real Effective Exchange Rate down sharply, the ECB has been less successful with EUR. However, increasing economic fragmentation within the Euro Area alongside the rising populist threat upcoming member-country elections all suggest a weaker EUR.

On a positive note for the ECB, global reflation pressures afford them greater scope to implement EUR weakening policy. During times of global, deflationary pressures there was little the ECB could do to affect a weaker EUR. The combination at the time of inflation expectations falling faster than nominal yields and the balance sheet pressures experienced by local financial institutions were preventing the capital outflows needed to weaken EUR.

EURUSD


The technical picture for EURUSD shows price still clinging to the 2015 lows, currently having breached the level several times but managing to hold just above it for now as the US Dollar retraces from recent highs. Price is now sitting on the supporting trend line of a broad bearish channel that has framed price over the last 18 months. Whilst channel support continues to hold there is a risk of a short-term correction higher with mid 1.08s the next clear structural resistance.

The December FOMC minutes released yesterday revealed that the Fed is very “uncertain” on the economic outlook and are waiting more information about “Trumponomics” noting that “growth might turn out faster or slower than they currently anticipated” depending on the President’s policy mix. However, the Fed did note that “almost all” members of the committee feel that there are upside risks to their growth forecasts relating to the likely fiscal boost which has not yet been considered.

Thursday, 05 Jan, 2017 / 2:33

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Source : https://www.orbex.com/blog/2017/01/reflation-affecting-euro/

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