Investors salivating over the prospect of the European Central Bank gradually reducing asset purchases and stimulus measures pushed the euro to a one-year high against the dollar earlier in the session. More hawkish remarks delivered on Tuesday by European Central Bank President Mario Draghi suggested that the deflationary headwinds once responsible for inhibiting the outlook have since ebbed, paving the way for stronger growth and a reflationary environment.
Nevertheless, while the threat of deflation has passed, the one lingering concern for policymakers is the likelihood of low inflation for an extended period. Even though these more hawkish remarks about the inflationary environment sparked a buying frenzy in the euro, there are still some factors that could derail sustained gains for the common currency. For one, the base effect of the energy price rebound is largely behind us, suggesting that without another catalyst to spur upside in consumer prices, inflation may languish during the upcoming quarters.
Despite strengthening growth in the euro area alongside improved employment and better household lending fundamentals, weak inflation may delay anticipated purchase tapering during the second half of the year. Furthermore, some of the factors that have weighed heavily on the US dollar such as the recent decision by the US Senate to postpone a critical vote on the healthcare bill until after Independence Day, are not permanent. After languishing at low levels for months accompanied by an uncertain policy outlook, US efforts to tighten monetary conditions by trimming the balance sheet and raising rates could be the catalyst behind a sharp EURUSD reversal over the medium-term.
Though dollar weakness helped smooth the latest move higher, the currency’s battered state over the last few months could give way to a tremendous rally, especially given the rapid approach of trade renegotiation. The prospect of ECB tightening is overwhelmingly positive for the Euro, but whether this undertaking materialises depends on the Euro Area reaching a sustainable pace of inflation. Any failure in this area could negate the more bullish euro sentiment prevailing among market participants.