FX Update: Oops, what if inflation is running hot everywhere?

FX Trading focus: While EURUSD eyes 1.2000, EU inflation comes in hot

Today’s EU inflation print generated significant attention, with the +0.9% year-on-year headline reading far north of the +0.6% expected and the core inflation hit a “heady” 1.4% versus +0.9% expected, the highest reading since last 2015. It is difficult to know how much to read into this data point, coming as it does amidst the region’s comprehensive virus lockdowns. Some of the factors, like a reversion in the German VAT at the beginning of the year to its pre-Covid level, are clear one-offs that boosted inflation for the month, while others, in particular the enormous spike in container shipping prices, may persist, although at multiple of historic norms, it is hard to conceive that shipping prices can continue to rise at anything approaching their recent pace.

Still, the shift higher in inflation comes even ahead of the basing effects of March and April of last year, when the virus impact crushed commodity prices and inflation gauges, and it fits with a pattern of inflation seemingly running hot everywhere (even in Japan, the Jan. prints for Tokyo CPI picked up to a positive level YoY). The key will be in whether a gush of personal savings and pent-up demand hit the economy as normalization of activity picks up, and especially whether under-investment in black energy will see the supply buffer quickly disappear and possibly drive oil prices much higher.

For FX, the question is then whether inflation become more globalized and not somewhat more concentrated to the US on its outsized fiscal response and anticipation of more negative rates there – that has been a pillar of the USD bear case. From here, it will be especially worth our while to note the relative real interest rate developments (policy and even 10 year yields less inflation) as a fundamental driver. If the US 10-year stays near 1% and US core CPI rises to 2.5%, that still looks better than a Euro Zone core inflation of 1.5% and German Bund yield of -0.5%. To be sure, if activity is normalizing and the Fed fails to signal greater QE or a yield-cap policy, without an increasing portion of savings, domestic or foreign, heading into US treasuries, US long yields will have to go higher.

Of course, there is also the current account angle, where the US suffers persistent deficits while the Euro Zone, for example, runs a surplus, but how the capital account shifts in one direction as it must to offset the current account will in part be determined by the real risk free returns available  in any region.

Chart: EURUSD
EURUSD is clearly mulling whether to have a look below the 1.2000 level here, the psychological pivot point for this trend, although a more critical medium term level might be the 1.1890 area 61.8% Fibo retracement of the rally wave  from the November lows. On the flip-side – a quick sharp rally back above perhaps 1.2100 needed to indicate that this has been a false downside break.