Buy the euro as US and Europe’s inflation trends diverge

By:
on Aug 14, 2023
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  • Inflation fears in the United States recede but it is different in Europe
  • The divergence in inflation trends favors a "buy the euro" setup
  • The ECB is forced to do more while the Fed has more flexibility

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Inflation was the main driver of the currency market’s volatility in the past twelve months. Fears that inflation is out of control in developed economies led to increased volatility surrounding central banks’ interest rate decisions.

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After all, central banks reacted by rising rates in the face of rapidly rising prices of goods and services. What the Fed did (i.e., hiking the funds rate aggressively) was mimicked by the European Central Bank (ECB), the Bank of England (BOE), and the Bank of Canada (BOC).

It was a race to raise rates as much as possible. Under such an environment, it wasn’t easy to pick a currency and hold it with a medium and long-term horizon.

But now, the inflation trends have started to diverge. More precisely, inflation fears recede in the United States, but Europeans still expect higher prices of goods and services in the months ahead.

Therefore, we might be at the start of a cycle where the Fed in the United States ended the rate hiking phase while the ECB is forced to hike some more. Under such an environment, the euro, and the EUR/USD in particular, are bullish.

US consumer inflation expectations trend lower

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One of the most difficult tasks of a central bank is to anchor inflation expectations. In other words, if households and businesses expect higher prices in the months ahead (six months or even a year), the central bank has a difficult time bringing inflation down to the target.

Therefore, anchoring inflation expectations is critical to central banks, and the market participants carefully monitor the changes in inflation trends.

In the United States, consumer inflation expectations trend lower, giving the Fed more flexibility in setting the rates – it can pause the rate hiking or even end it.

However, it is not the same in Europe.

European consumers still worry about inflation

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A recent study conducted by ING in various European countries, such as Germany, Spain, the Netherlands, or Luxembourg, shows that people expect higher prices than normal for at least three more years.

Households have reported that they spend more on food and groceries than five years ago. Also, they save less.

This reflects the difficult task the ECB has in its fight against inflation. Bringing it down to the 2% target requires more action, in contrast with where the Fed is.

Under such developments, one can build a bullish case for the euro. Buying the euro against the US dollar or the Japanese yen on pure fundamental analysis to speculate on the change in inflation trends might be the trade for the rest of the year.

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Bank of Canada Bank of England Canada EUR European Central Bank JPY Central Banks Europe Forex Inflation Interest Rate North America