Forex Trading Library

European Final CPIs and Yield Gap

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With all the focus on G20 and COP27, many European leaders have been out of the continent. News has been relatively sparse, which has allowed the shared currency to drift higher. In the last couple of weeks, it made a couple of runs at parity before finally breaking through thanks to US CPI figures. That opens the question of whether the trend will continue higher, or there will be a return to parity.

For now, the market has to run without proximal intervention from central banks. Both the ECB and the Fed won’t meet until a month from now. Thus, focus has to remain on data. Recent data has been relatively good for both economies. But with the different postures of the central banks, market reaction has been in opposite directions.

Wait.. data has been good?

The most recent macro data from Europe was September industrial production that came in above expectations. But that had more to do with forecasts being relatively low due to higher energy prices and reports through the summer that businesses were either reducing output on winding down operations. Since the expectations were priced in, it’s a relatively good result.

The main issue is that Europe has high and growing inflation, while recent trends in the US suggest inflation is slowing down. Better economic data means the ECB can keep hiking. Meanwhile, lower inflation in the US means that the Fed could be less aggressive.

How wide can the gap get

The main driver of the Euro below parity with the dollar was the gap in real interest rates. Sure, there was also an effect from general market uncertainty driving investors to the safety of the dollar. But, real yields tell the story about whether it’s worth more to have funds in dollars or Euros. Or, more accurately considering the circumstances, which loses less value.

With America’s high interest rates and slowing inflation, it means that holding dollars loses less value than holding Euros with lower interest rates and higher inflation. But, that situation might have reached its, and be about to reverse. As inflation in the shared economy pushes into the double digits, the ECB will be under more pressure to raise rates. With inflation coming down, the Fed could slow hiking. Meaning that the real rate gap could be about to shrink, and that could push the Euro higher.

So, no return to parity?

Not necessarily. Over the last couple of days, Fed officials have come out to say that the market is getting ahead of itself on speculation that rates won’t be rising as fast. And ECB officials have been relatively quiet over the past few days. The initial move higher in the EURUSD was driven more by speculation than reaction to direction from either central bank.

Europe is still facing a challenging winter, and that might keep the ECB from tightening for a while longer. Meanwhile, US core inflation is still triple the Fed’s target. Both sides of the Atlantic seem to agree that inflation is pushing recession risk. Hence, the argument that they have to care about a recession is likely also an argument that they will double down on the fight against inflation.

Eurozone October Final CPI is expected to be confirmed at 10.7%, up from 9.9% in September.

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