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FX Update: Oops, what if inflation is running hot everywhere?
John J. Hardy
Chief Macro Strategist
Summary: EURUSD continues to coil around just above the pivotal 1.2000 on a day that saw the hottest core CPI reading out of the EU in almost five years, and that before we see the basing effects of the collapsing prices in the spring of last year. Today we look at whether the inflation genie out of the bottle everywhere is less bearish for the US dollar and look at one indicator possibly suggesting that the JPY is getting unjustifiably weak.
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.
The JPY and yields
I have long maintained that the most important focus for the JPY in terms of its “safe haven” status is in watching the long end of the US yield curve far more than risk sentiment, for example, in equity markets. But as Kit Juckes, the great FX analyst over at SocGen, reminded me in his piece today, long US yields have proved a sorry indicator for at least a few months and might indicate that this will continue to be the case. I think in the near term the rising yields in the US have played a part in the JPY trading weakly, but that in the background, a better safe have indicator is more likely to be something like emerging market spreads, as the legendary Japanese saver has historically often been more interested in investing in bonds, and therefore carry, than in equities. On that note, we can see that the general JPY weakness since the pandemic panic fits quite well with the ongoing crush lower in EM credit spreads as discussed in the chart below, but recent developments look a bit over the top (JPY too weak?).
Chart: JPY versus EM credit spreads.
This chart shows the JP Morgan real effective Japanese yen versus a JP Morgan of EM credit spreads. Two things to note: the directional sympathy of the two and the quite cheap level of the JPY. If central banks continue to prevent price discovery in credit, turbulence in other financial markets may offer little support for the JPY, but if EM currencies themselves back up badly, especially together with any new notable spread widening in EM credit, the JPY could be in for a significant rally, given its current valuation and the risk that positions have gotten somewhat aggressive after a very long run in favour of these kinds of carry trades.
SuperMario as Italian Prime Minister makes for interesting EU politics.
Will follow up more on the Saxo Market Call with our resident Italian fixed income strategist and Italian native Althea Spinozzi, but it is a fascinating development to see former ECB president Mario Draghi called on to create a new technocratic Italian government. In an EU context, Draghi has to be one of the most persuasive voices to get things done for Italy by EU institutions if anything more can be done on Italy’s behalf, as he is the only identifiable candidate with the necessary weight and charisma. Italian 10-year yields are still 100 bps north of those for Germany – will Draghi be able to help crush these further?
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