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Sep 27, 2023

EUR/USD: German Inflation Data May Give the Euro a Lifeline. It Won't Last

By:Ilya Spivak

The euro may bounce if German disinflation is less dramatic than expected, but any gains are likely to be short-lived

  • The euro has suffered the worst bout of selling pressure in nearly three decades.
  • A rebound may be in the cards if German CPI drops less than economists expect.
  • Any gains the euro makes against the U.S. dollar are likely to be short-lived as yield spreads lock in.

The euro is sinking.

The currency is on track for an eleventh consecutive week of losses. That matches the longest streak of declines on record and the only other comparable episode of persistent weakness, from the first quarter of 1997.

What’s more, selling pressure seems to be strengthening.

The most recent part of the down move is a seven-day run of back-to-back losses. That’s the worst performance since December 2017. The latest drop comes after data from the European Central Bank (ECB) showed the drag on economic growth from tighter credit conditions is the most pronounced since the global financial crisis and greater than during the subsequent Eurozone debt crisis.

Base effects to cool German inflation, keep the ECB on pause

Incoming German inflation data seems unlikely to offer much of a counter-narrative. The headline consumer price index (CPI) measure of price growth is projected to slow from 6.4% year-on-year in August to 4.5% in September. That would be the lowest reading in two years. That will foreshadow a similarly emphatic downswing expected in regional-wide figures due a day later.

Most of the decline is expected to come from base effects. The influence of Germany’s subsidy public transportation subsidy as well as a host of assorted statistical distortions coming from changes in the composition of the CPI basket are due to fall out of year-on-year calculations. The seasonal uplift in recreation and other summertime spending categories is also likely to weaken. Food inflation looks to be on a declining path as well.

german hcpi yy components
Data source: Bloomberg

This seems to give the ECB a straightforward way to justify a pause in interest rate hikes. The euro plunged after the central bank’s mid-September policy meeting where it signaled that this month’s 25-basis-point (bps) increase may have capped the tightening cycle.

The markets price in no further rate hikes. The probability of another increase in 2023 has dropped to just 20%. Officials are expected to throw the process in reverse in the second half of 2024. The first 25bps cut is penciled in to appear no later than July, despite ECB President Christine Lagarde saying the bank isn’t even thinking about easing.

Euro may bounce but trend change is unlikely

On balance, this means that – absent dramatic and thereby inherently improbable undershoot – the downswing in German CPI is unlikely to change investors’ outlook in a way that demands still more euro selling. An upside surprise in the event that base effects add up to less disinflation than economists anticipate seems like a more plausible market mover.

That might arrest euro weakness if traders reckon that the ECB might hold off on rate cuts for a bit longer than investors’ current thinking. Conveniently enough, prices have arrived at chart support marked by the low for the year set in January, making this a natural place for the selloff to pause for a rethink.

If the currency does manage a rebound, the up move will probably amount to a correction rather than an outright change of trend. The Federal Reserve and the ECB are both in a holding pattern after their latest policy updates. Implied market pricing suggests this has locked in a US dollar yield advantage of 140-150bps over its Eurozone counterpart for at least a year, making it broadly unattractive to own euro relative to the greenback.

Eur usd yield curve spread
Data source: Bloomberg

Ilya Spivak, tastylive head of global macro, has 15 years of experience in trading strategy, and he specializes in identifying thematic moves in currencies, commodities, interest rates and equities. He hosts Macro Money and co-hosts Overtime, Monday-Thursday. @Ilyaspivak

For live daily programming, market news and commentary, visit tastylive or the YouTube channels tastylive (for options traders), and tastyliveTrending for stocks, futures, forex & macro.

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