Euro falls as inflation data puts ECB cut back on the table

Tom Tong31/Mar/2014Currency Updates

It was a rather quiet week in FX markets as major currencies moved within fairly tight ranges. The main news of the week came out of the Eurozone, with surprisingly dovish comments from Bundesbank President Weidmann, followed by downward surprises in Spanish and German inflation. Renewed expectations that the ECB may cut rates put downward pressure on the euro against the dollar and sterling. The latter received additional support from strong domestic data releases and ended the week higher against all major G10 currencies.

GBP

Service sector output for January showed a stronger than expected 0.4% gain, and December’s number was revised higher as well. This reading raises the possibility that first-quarter growth will print nearer to 4% than 3%, a stronger outcome than most analysts are expecting. Inflation data for February was mixed. The headline number dropped to 1% from 1.9%, but core inflation (excluding volatile food and energy components) rose slightly to 1.7%, which means deflation is for now a distant possibility in the UK. With such a supportive macroeconomic backdrop, it was no surprise that sterling rose steadily against both the euro and the dollar last week.

EUR

The euro received some support earlier in the week from stronger than expected PMI business sentiment numbers, which pulled back only slightly in March from February’s healthy level. However, the common currency took a spill mid-week as, uber-hawk Bundesbank President and ECB Governing Council member, Jens Weidmann surprised markets by appearing to drop his objection to direct purchases of Government bonds by the ECB. This was followed on Friday by serious downward surprises in inflation data out of Spain and Germany. Data from the former is particularly worrying as the YoY number fell back to -0.2% in March, raising the spectre of damaging deflation in the highly indebted Spanish economy. While we do not expect a cut from the slow-moving ECB at this week’s meeting, we think that the danger of Eurozone deflation will dominate the discussion both within the meeting and at Draghi’s press conference, and expect the ECB to signal that it is getting ready to cut rates further if inflation does not rebound as its staff expects. With monetary policy in the Eurozone moving in the opposite direction from that of the Bank of England and the Federal Reserve, we expect the euro to struggle against sterling and the dollar over the medium term.

USD

Real consumer spending, capital goods shipments and pending home sales in February all came out softer than expected. Again, however, it is unclear how much of this softness is due to the severe weather and how much reflects a genuine slowdown. High frequency indicators, such as weekly jobless claims, paint an optimistic picture, with both the headline and the 4-week average near cyclical lows just above 300,000. As we draw nearer the all-important payroll report next week, we expect that the Federal Reserve will continue to ignore near-term softness in second-tier indicators and continue to taper its asset purchases by $10 billion in each upcoming meeting.

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Written by Tom Tong

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