The world’s two largest economies appear to be continuing down different paths.
The likely result is that the euro will find itself stronger than the dollar in the coming months. However, that depends on whether the data trends continue.
In fact, tomorrow we’ll be getting a hint as to whether Europe and the US are diverging or converging as the recovery gets underway.
An interesting thing to note was yesterday’s comments from ECB President, Christine Lagarde. The ECB head informed EU leaders that she expected the economy to return to pre-pandemic levels by the first quarter of next year.
She also expects inflation to keep rising until autumn but insisted that the higher rate would be transitory.
So what’s next for the two largest economies?
The context matters
The thing is, the pre-pandemic situation was very different for the US and the EU.
So, if both economies were aspiring to return to where things were before covid, they would be aiming for rather different targets. And this has important implications for the markets.
Specifically, pre-covid, the EU was growing at an anemic 1% annual, which was half the rate of the US. Moreover, the Fed was on a rate-hiking trajectory, while the ECB had kept rates negative.
Therefore, the “normalization” of rates for the US implies cutting back on asset purchases and eventually raising rates. whereas for the ECB, “normalization” implies negative rates, and potentially further expanding the balance sheet.
So, what does this mean for the EURUSD?
At first glance, lower interest rates for the common currency would suggest weakness. Having said that, it’s not necessarily true when we compare inflation expectations.
Economists expect euro area inflation to be 1.4% this year, while US inflation is likely to come in at 2.1%. Both of these projections are considered to be quite optimistic (especially on the US side). However, the real yields in Europe are higher. In fact, we can expect them to remain so, even if the Fed starts tapering.
Of course, there are potential snags.
Euro-area inflation could unexpectedly pick up. The most recent spending foray of the Biden administration hit a road bump after it turned out the bipartisan deal came with partisan strings attached. This is why we need to watch inflation closely.
Inflation is most likely to be the driver of yields between the two most-traded currencies in the world.
Expectations are for both central banks to remain on the sidelines for the rest of the year in terms of rate policy. So, fluctuations in currency, and in the stock market with export-dependent companies, are likely to rely on changing expectations for the data.
What are we looking for
Analysts expect the European June CPI to show a marginal slowing of the pace to 1.9% compared to 2.0% in May. One decimal could be due to rounding, so it’s not a major change.
That said, whether flat or declining, it does suggest that inflation isn’t a major pressure on the shared economy at the moment.
Core June CPI could come in at 0.9%, compared to 1.0% in May. That’s half of the ECB’s target. However, it should be noted that these are preliminary numbers, and could suffer some minor modification when we get the final results next month.