US inflation relief adds to risk appetite

USD: Inflation data help risk appetite

The sudden jump for the US dollar in London afternoon trading yesterday looked suspiciously like month-end related dollar demand with no obvious catalyst for the move. The DXY index advanced 0.5% in the period around the London fix and much of that gain remains intact today with euro-zone inflation in focus after yesterday’s PCE data in the US. The PCE data as expected highlighted a rebound which was well telegraphed and the fact that there was no upside surprise on top of the expected acceleration helped provide some relief to the markets. The “supercore” PCE was certainly alarming with a jump of 0.6% m/m, the biggest gain since December 2021. Financial services & insurance accounted for the largest part of that increase, at about one-third of the total increase and is a reflection of the strength of equity markets.

But there is no reason to believe the disinflation trend is about to end and the reaction in the markets yesterday indicated confidence that inflation will continue to fall. Today, the euro-zone CPI data will be released and the country data yesterday was certainly consistent with further notable declines to both the headline CPI and core CPI rates. The core CPI is set to fall to 3.0% or 2.9%, the lowest level since Feb/Mar 2022 and further proof that inflation is falling faster than the ECB has been assuming. Underlying euro-zone inflation is falling faster than in the US highlighting strong disinflation momentum. In the US, the core PCE has fallen 2.57ppts over 16mths since September 2022. In the euro-zone core CPI will have dropped by 2.7ppts in 10mths.

The ECB remains overly cautious in our view and we maintain over the short-term that there is a bigger risk of a sooner pivot from the ECB than the Fed. The updated forecasts next week will see cuts to both GDP growth and inflation. Inflation forecasts for 2025 and 2026 are already around target at 2.1% and 1.9% so that will make it difficult for EUR/USD to make any sustained move higher over the near-term.

Favourable financial conditions look set to continue for now but event risk next week could potentially see some pick-up in FX volatility that could help support the G10 FX underperformers – the yen and Swiss franc. Chancellor Hunt will present the budget and Fed Chair Powell will deliver his semi-annual testimony on Wednesday; the ECB monetary policy meeting with updated forecasts is on Thursday and then we have the US employment data on Friday.

SUPERCORE 3MTH & 6MTH ANNUALISED RATES POP HIGHER

Source: Bloomberg, Macrobond & MUFG GMR

GBP: Recent developments pound supportive

The pound continues to track the performance of the euro with little evidence of any market view on any divergence on the horizon that would prompt the pound to break out of recent narrow trading ranges. EUR/GBP 3mth implied volatility has fallen sharply this year, close to the 4.0% level – a volatility level last seen just prior to the Global Financial Crisis in 2007. A very big macro factor that hit both the euro-zone and the UK in nearly equal measure was the huge energy price shock after Russia’s invasion of Ukraine two years ago – a development that hit both economies much harder than the US but a development than is fast fading as natural gas prices hit new lows and levels not seen since 2021. It’s hard to view the current levels of volatility in EUR/GBP as justified given the high level of uncertainty on what lies ahead and it appears there’s a level of complacency over the outlook that indicates attractively cheap levels for FX hedgers in current market conditions.

We certainly see a greater risk of further divergence in forward rates pricing given the communications from the BoE remain concerned over sticky services inflation and wage growth in a labour market that is a lot tighter than in the euro-zone. Catherine Mann, who is the most hawkish MPC member, put forward one example of sticky services inflation – high-income households continuing to spend because they are much less impacted by rising mortgage rates – that could mean inflation is a lot slower to sustainably return to target. Given headline inflation is now forecast to drop below target by the BoE in Q2, the underlying inflation data will be even more important over the coming months along with wage data. The ISM Services Output Price index that is a more forward looking doesn’t bode well for an imminent notable slowdown in services inflation. Mortgage applications have jumped to the highest level since Oct 2022.

In addition we had the interesting comments this week from Deputy Governor Ramsden who stated that the BoE could continue to run down its securities holdings under the current QT program beyond the perceived equilibrium level (“preferred minimum range of reserves”). The BoE could use other tools to manage day to day liquidity conditions instead of keeping Gilt holdings at a certain level. With BoE losses covered by a Treasury indemnity this will cost the government and raises political risks. Other central banks are suffering losses but the Bundesbank for example announced it would book these losses and run them down on future profits. We doubt the ECB or the Fed will pursue a similar policy if that’s what the BoE does. Finally, incoming new Deputy Governor Lombardelli could add to MPC caution based on her previous most recent comments at the OECD. An August rate cut as a first from the BoE is looking most likely now which opens up divergence potential to shake EUR/GBP from the current extraordinarily low levels of volatility.

UK SERVICES PMI SHOWS DISINFLATION MOMENTUM HAS FADED

Source: Macrobond & Bloomberg

KEY RELEASES AND EVENTS

Country	GMT	Indicator/Event	Period	Consensus	Previous	Mkt Moving
GE	08:55	German Manufacturing PMI	Feb	42.3	45.5	!!
IT	09:00	Italian Monthly Unemployment Rate	Jan	7.2%	7.2%	!
EC	09:00	Manufacturing PMI	Feb	46.1	46.6	!!
UK	09:30	Manufacturing PMI	Feb	47.1	47.0	!!!
EC	10:00	Core CPI (YoY)	--	2.9%	3.3%	!!!
EC	10:00	Core CPI (MoM)	--	--	-0.9%	!!!
EC	10:00	CPI (YoY)	Feb	2.5%	2.8%	!!!
EC	10:00	CPI (MoM)	--	--	-0.4%	!!!
EC	10:00	Unemployment Rate	Jan	6.4%	6.4%	!
UK	14:00	BoE MPC Member Pill Speaks	--	--	--	!!!
CA	14:30	Manufacturing PMI	Feb	--	48.3	!
US	14:45	Manufacturing PMI	Feb	51.5	50.7	!!
US	15:00	Construction Spending (MoM)	Jan	0.2%	0.9%	!!
US	15:00	ISM Manufacturing PMI	Feb	49.5	49.1	!!!
US	15:00	Michigan 1-Yr Inflation Expectations	Feb	3.0%	2.9%	!!
US	15:00	Michigan 5-Yr Inflation Expectations	Feb	2.9%	2.9%	!!
US	15:00	Michigan Current Conditions	Feb	81.5	81.9	!
US	15:15	Fed Logan Speaks	--	--	--	!!
US	15:15	Fed Waller Speaks	--	--	--	!!
US	17:15	FOMC Member Bostic Speaks	--	--	--	!!
US	18:30	FOMC Member Daly Speaks	--	--	--	!!
US	20:30	FOMC Member Kugler Speaks	--	--	--	!!

Source: Bloomberg