German CPI Preview: There is a Short Euro Trade to Consider if Soft Data Cools ECB Rate Hike Bets

By:Ilya Spivak

The Euro will probably face the worst of selling pressure if German CPI inflation data cools ECB rate hike bets

  • German inflation data to highlight ECB stagflation puzzle despite prices cooling.
  • Food prices are tough to affect with tightening as the economy sinks into recession.
  • The euro may fall if CPI prints softer than expected, downgrading rate hike outlook.

The euro is in sellers’ crosshairs as German consumer price index (CPI) data puts the spotlight on the stagflation puzzle facing the European Central Bank (ECB). Policymakers are trying to tame price growth in an economy on the cusp of recession, if not already in one.

The currency bloc’s largest economy is expected to report that headline inflation fell to 6.3% year-on-year in August, down from 6.5% in July and matching the 15-month low recorded in May. While that’s a significant climbdown from the peak at 11.6% in October 2022, it remains miles away from the ECB’s target 2%.

Can the ECB bring down German inflation?

Most of the problem is still on the “goods” side of the ledger, unlike services-driven inflation in the U.S. Falling gas prices have been the main driver of disinflation from last year’s highs. Food prices have taken over as the largest contributing factor, with bread and cereals making up the biggest piece of the pie.

german hcpi yy components
Data source: Bloomberg

This makes for a thorny problem for the ECB. Trying to bring down food inflation with interest rate hikes is a tough job in the best of times. There’s not much that the central bank can do with borrowing costs to turn off hunger or reroute demand for basic staples, like bread.

It is harder still when the economy is already shrinking. The latest set of Purchasing Managers Index (PMI) surveys from S&P Global showed manufacturing- and service-sector activity growth contracted at the fastest pace in 39 months. Nevertheless, market-based measures of inflation expectations are trending higher and beckoning the ECB to act.

Euro may suffer if soft inflation data cools rate hike bets

The dire economic situation has already weighed on the outlook for ECB action. Traders now price in a 76.5% probability of another 25-basis-point (bps) rate hike by year-end, which they expect will cap the tightening cycle. That marks a modest cooling from certainty (i.e., 100% priced-in probability) in this outcome after the central bank’s last meeting in late July and the 85% chance assigned to it a week ago.

citi eurozone economic surprise index
Data source: Bloomberg

Realized economic data outcomes from the Eurozone still tend to undershoot baseline projections according to data from Citigroup. The margin of disappointment improved a bit in August, but figures from Bloomberg suggest that this reflects downgraded forecasts rather than improvement in the economy’s momentum. So, surprise risk still looks to be tilted on the downside.

A soft result may continue to work against the odds of another ECB rate hike, giving the central bank some cover to hold back tightening the screws on an already suffering economy. That is likely to weigh on the euro against the U.S. dollar, where it would amplify a widening of yield differentials against the common currency. Rate spreads have already moved by close to 100bps in the greenback’s favor over the past four months amid repricing for a more hawkish Federal Reserve.

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

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