The latest inflation data from the Eurozone indicate a substantial jump in inflation in Europe's largest economy in December, eliciting calls, especially from Germany, that the European Central Bank president Mario Draghi, end his ultra-loose monetary policy and raise the ECB's policy rate. Draghi once more faces the wrath of Germans fearful that savers face devastation due to zero or even negative interest rates, and fretting that the supposed "guardian of price stability" will let them down, even as domestic inflation starts to rise.
This reaction is natural in Germany, where people have been conditioned to fear inflation. But the situation is complicated by the fact that the ECB sets monetary policy not only for Germany, but for the whole euro area. Moreover, there is a wide disparity in inflation rates among euro area countries - Germany happens to have the highest Harmonized CPI in December, if tiny Lithuania is excluded (see chart below, latest available data).
On a eurozone-wide view, the numbers are more benign - CPI growth in the currency bloc is at 1.1 percent in December, almost twice as fast as the previous month but still well below the goal of just under 2 percent. The ECB predicts euro-area inflation won't reach that target until at least 2019.
ECB policymaking in the past several years has been conditioned by the slow economic growth in the euro area and the actual fear of deflation, driving the central bank to adopt radical measures, like negative interest rates, in efforts to underpin growth. The ECB's drive towards zero and even negative rates has been the biggest single factor that has kept the EUR lower against the US Dollar over the past several quarters.
However, the first inflation data in the new year brings a reminder of just how strong the German economy has become during this time. The number of jobless fell more than forecast in December. The unemployment rate remains at a low of 6 percent, and inflation (boosted by higher energy, food and goods costs) increased a record 1.7 percent from 0.7 percent (see chart below).
The reaction to the data was immediate and predictable - Bloomberg News reports that Clemens Fuest, president of the respected Munich-based Ifo research institute, called on the ECB to consider ending its bond-buying in March, which the ECB Governing Council decided just last month to extend the program until at least the end of 2017. Germans, who are some of the world's great money savers, have always been leery of the ECB's bond-buying program, and the low interest rate regime that comes with it.
Bild, Germany's most-read newspaper, in an opinion piece wrote that people "are seeing a net devaluation of their savings while governments in euro countries can continue borrowing at historically low costs," in a regime of rising inflation while deposit accounts' interest rates are at near zero. The Handelsblatt newspaper reported that Germans could lose tens of billions of euros a year on the real value of their savings under those conditions, which Bavarian Finance Minister Markus Soeder told the paper would be "devastating."
The reality is that with energy costs rising quickly in the past few months, the strong disinflationary pulse that the globe had seen in 2015 and during the early part of 2016 has been all but neutralized. The deflation meme, as we stated before, is dead. Inflationary expectations have jumped up in Europe, and along with rising inflationary expectations in the United States, the picture emerging is that in which inflation may become an issue again for investors and central banks across the globe in the near future.
So far, we see that rising inflation in the US and in Europe is being driven by the rapid rise in energy costs during the past four quarters of 2016. Will the inflation uptick be sustainable if energy prices are taken down a notch, as we expect in Q1 2017? Given the single universal price of crude oil, will inflation rise faster in Europe relative to the US, or is it the other way around?
These questions are being asked as comparative inflation rates often play large roles in the USD-EUR relationship. During certain periods in the immediate past, inflation differentials were instrumental in driving the valuation of the USD versus the euro, as much as interest rate differentials did (see chart below).
Inflation has been relatively higher in the US since early 2015, but the lower EU inflation rate since then did not help the common currency as swap and yield spreads predominantly favored the US Dollar over the euro at that time, a condition which still persists today. But as the chart above shows, relative inflation rates played a major role in the EUR-USD relationship during the period up to Q2 2014. During those earlier periods, the higher inflation rates in the US were part of the reasons why the US currency was weaker versus its EU counterpart (see chart above).
Then by late 2014, the interest rate spreads turned massively in favor of the US Dollar as the ECB aggressively eased monetary policy. In fact, it was the sharp decline in inflation (actual and expected) which drove the ECB to engineer a rapid decline in interest rates, which subsequently brought about a persistent decline in the valuation of the common currency.
Nonetheless, there is now a growing gap between the inflation rates of the two regions as US inflation rates rise sharply, as shown by the chart above (red line). Although inflation as a valuation factor has been overshadowed by the overwhelming impact of rate differentials favoring the US unit, there would come a point where significantly higher inflation rates in the US would start to hurt the USD and weaken its valuation against the euro.
It also helps that with domestic inflation rising quickly, the change rate of Germany's bond yields is stabilizing. Germany's balance of payments Capital Account is also starting to rise, suggesting that investment capital which fled the Eurozone is starting to be repatriated, and should help strengthen the common currency in the near future (see chart below, green line).
There is this persistent belief in the markets that higher long-term interest rates (the 10yr yield as proxy) pushes up the value of the US dollar. This belief is misguided. That has not been true since global finance came out of the Great Financial Crisis (GFC) of 2007/2008 during Q2 of 2009. Since then, changes in the US Headline CPI have been ahead of the changes in the 10-year yield and the US dollar. The new comovements post-GFC: changes in CPI are positively correlated with, and lead the changes in the long bond yield, and changes in both CPI and 10yr yield lead the negative changes in the US dollar.
These post-GFC relationships have held true even in the periods before, during, and after the Fed tightened policy in December 2015. It remained the case until late August 2016, when the US Dollar started to strengthen even as the CPI and the 10yr yield rose (see chart below).
The inflation situation in the US is, and has been, significantly different from that of the eurozone's. US Core CPI has been sideways since February last year, after a sharp push in most of 2015, bringing the index above 2.0%. The Fed targets the Core PCE's change rate, which is still slightly below the Fed's target of 2%, but the recent high energy prices will soon percolate into the PCE, and we expect the Fed's inflation target to be met by 3Q 2017 (see chart below). This outlook contrasts sharply with that of the Eurozone - the ECB predicts euro-area core inflation won't reach their 2% target until at least 2019.
Normally, we do not invoke the Fed's and ECB's inflation targets in a discussion of relative currency valuations, as both central bank's core inflation targets have been similar in recent years. But the recent schism shown in the US Headline CPI-long bond yield-US Dollar relationships may have its origin in developments in the core inflation universe. It turned out that there is a new player in the inflation Index, long-term rates, and US Dollar triangle - the US Core PCE Index (less Food and Energy components).
Unlike the leading function of the US Headline CPI on US rates and the US Dollar, the Core PCE tended to lag behind developments in rates and the US currency. But that has changed in July when the Core PCE monthly changes started to fall sharply even as corresponding monthly changes in rates and the US Dollar rose sharply (see chart below).
The divergences we saw in the Headline CPI relationships, and now in the Core PCE comovements, led us to believe that the long bond yield rally was driven primarily by the sharp rise in CPI, while the sharp ascent in the US Dollar was impelled primarily by the aggressive decline in Core PCE inflation. Those developments make sense if considered separately, but based in the context of recent relationships, they don't if taken together. The most puzzling of all - the positive correlation between the long bond yield and the Core PCE has completely broken down (see chart below).
There is evidence from academic work that the negative correlation between crude oil and the US Dollar flows from the former to the latter (e.g., Coudert, Mignon, Penot, 2005). We can also show empirical evidence that this is indeed the case based on our studies, and we have shown that in a previous Seeking Alpha publication as well (see that here); the correlation may also be seen in the two subsequent charts below.
In fact, we believe this is the linkage leading to the negative correlation between the US Dollar and CPI inflation, headline or core. As we showed in the previous charts, inflation negatively leads the US Dollar, and since crude oil leads CPI, then the proper conclusion is that higher oil produces higher inflation, which tends to weaken the US currency. The outlook for near-term oil prices, on account of the OPEC and Non-OPEC agreements to cut oil production, is significantly bullish, as can be expected.
However, we believe that there are short-term negatives in the oil fundamentals, which may depress oil prices in early Q1 2017, but by mid-year, the production cuts should start to push prices higher. It may also be that severe Capex cuts in the past two years, and over the next coming years (up to 2020) should prime higher oil prices, with negative consequences to the US currency for some time (see chart below).
Our short-term outlook is for the US Dollar to strengthen until mid-February, after which the US currency should weaken significantly against the euro and other major currencies, given those relationships, and summarized by the chart shown below.
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