Inflation may become the hot new topic for financial markets as we move into the latter stages of the summer months. The July CPI rate for the Eurozone came in stronger than expected at 2.1%, the fastest rate of price growth since 2012. Core prices are also rising, albeit at a slower pace, to 1.1%.
Price growth is starting to weave its way into the financial narrative after a plethora of US companies announced price rises in recent months including Starbucks (NASDAQ:SBUX), Colgate-Palmolive (NYSE:CL), Chipotle (NYSE:CMG) and US rail companies, blaming the price rises on higher input costs.
While consumer prices may be held in check in the eurozone for now, they may not be for long, as headline inflation pressures have a habit of seeping into core prices with a lag.
Growth vs. Inflation, the ECB needs to decide
All of this makes life difficult for the ECB. Although the Bank has set the stage for a rate hike at some stage in late 2019, its mandate – to maintain prices at close to 2%- may mean that they have to start hiking prices sooner, particularly if this is the beginning of a trend for higher prices in the currency bloc.
Rising inflation has given the euro a boost, it is currently trading at $1.1730 – its highest level since late last week, the next resistance level to watch is 1.1750 – the high from last week, and then 1.1791 – the high from 9th July. How EUR/USD reacts as we lead up to the crucial $1.18 level is worth noting.
The ECB is essentially on a summer break during August, so the market will have to speculate whether the ECB will react to stronger inflation or to weaker growth - Q2 GDP was 2.1% YoY, down from 2.5% in Q1, and Spain’s growth for Q2 was at its slowest pace for 4 years.
Why it could be a good month for euro bulls
If the market expects the ECB to stand by its mandate, even in the face of slowing growth, then interest rate expectations may be brought forward. Even a subtle shift could boost the euro and $1.20 could be on the cards over the next few weeks. Of course, for euro bulls, the risk is that the ECB does not play ball, but with the ECB out of office for the next few weeks, the euro could have free reign to get back to $1.20 in August, a level that was last reached in April.
BOJ leaves it to fiscal policy to do the heavy lifting on price growth
Elsewhere, the BOJ failed to deliver a big shift in its monetary policy stance at its meeting earlier on Tuesday, even though expectations were high that it could deliver an end date to its QE programme.
The trouble for the BOJ, however, is the 2019 proposed increase in the consumption tax. A rise in Japanese VAT is a political hot potato that is resisted by voters and has been the undoing of many a Japanese government. However, with a debt-to-GDP ratio of 98%, the country is crying out for some form of tax reform. Thus, the BOJ has to consider the implications of a change in fiscal policy next year when it is planning monetary policy for this year.
Overall, we believe that the consumption tax binds the BOJ to stick to its current policy path because the fiscal reform could do enough tightening without the BOJ needing to intervene. Hence why 10-year JGB yields have given back 61.8% (key Fib level) of their recent gain on the back of today’s BOJ meeting. Japanese government bond yields may continue to rise, not because of BOJ policy, but because of the upcoming consumption tax.
Signs the dollar could slide into August
Overall, with the euro looking perky on the back of inflation pressures and an absent ECB, and with the yen’s decline most likely capped due to impending inflation pressures due to next year’s tax hike, the dollar may take the hit in August.
The dollar index has been stuck in a tight range between 95.60 on the upside and 94.00 on the downside in recent weeks, and it has recently fallen below its daily Ichimoku cloud support at 94.36, which is a bearish development. In the short term, a break below 93.90 could open the way to further weakness back towards 92.50 in the coming weeks.
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