Home Forex Markets EUR/USD Outlook: Undiminished core inflation, likely to spur ECB rate hike plans

EUR/USD Outlook: Undiminished core inflation, likely to spur ECB rate hike plans

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High core inflation in the euro zone has put the European Central Bank on track to raise interest rates in July, and the recovery of the euro comes at a time when capital flows are tapering off at the end of the month.

EU Economic Data Review: Core Inflation Remains Strong

Eurozone inflation rose 7.5% y/y, in line with market expectations, while the core reading was significantly higher than expected at 3.5% (vs. 3.2% expected). As a result, high inflation will further fuel expectations that the European Central Bank will raise interest rates starting in July, which is now close to being fully priced in by the market. Meanwhile, euro zone GDP grew at an annualized rate of 5% in the first quarter, while the quarterly rate was slightly below expectations of 0.3%, reaching just 0.2%. That said, the release of the data is unlikely to derail the ECB’s plans to accelerate monetary policy normalization.

The market reaction to the data was muted as the data were unlikely to significantly affect the near-term outlook for ECB policy. Investors are focused on Fed policy, with markets forecasting the prospect of a decision ahead of next week’s meeting.

Dollar retreats modestly amid month-end woes

Beyond that, with April trading coming to an end, market participants are looking to take the opportunity to downplay the dollar’s recent aggressive moves. It’s worth noting that in months where the S&P 500 is down 3% or more, the dollar tends to rally towards the end of the month and then retrace in the first week of the following month (as shown in the chart below). Still, most investors agree that the dollar is overbought, but the problem is the lack of an alternative to the dollar: there is little reason for investors to be bullish on the euro right now. However, the author will pay attention to the trend of the offshore yuan, if the trend turns around, the dollar may peak.

Explaining FX month-end rebalancing

London WMR Fix (4pm London time): The WMR Fix is ​​one of the most widely used benchmarks for foreign exchange trading and is conducted daily within a 5-minute window around 4pm London time. The WMR fix provides a standard set of currency benchmark rates so that stock and bond investors can compare the valuation and performance of their portfolios with each other.

WMR fixings tend to coincide with a sharp rise in trading volume, prompting a significant increase in liquidity. Sometimes this means that there is a lot of real money flowing, so it doesn’t cause too much distortion. However, the flow of funds can also dominate in one direction (strong buy or strong sell), resulting in large price movements in a short period of time.

The biggest fluctuations usually occur on the last business day at the end of the month. Markets are often extremely volatile between 3pm and 4pm London time – these FX market flows are largely driven by equity rebalancing.

Therefore, if investment managers in the UK hold USD-denominated assets and seek to hedge their foreign exchange risk, a monthly increase in the value of these assets will lead to more executions of USD-hedged (sell USD) trades. For example, if a stock is FX-hedged and the U.S. benchmark (S&P 500) is up for the month while the U.K. FTSE 100 is flat, U.K. investors will sell USD/GBP to increase the hedge; this move by investors The GBP/USD appreciates. U.S. stocks outperforming the U.K. is typically associated with more dollar-sterling selling, prompting further gains in the pound. Nonetheless, extreme moves usually partially resume on the second trading day following the month-end rebalance. That said, the occurrence of such events in a liquid market like FX shows that London market pricing (especially month-end pricing) is very important for FX traders. (Translated by Ashley by Justin McQueen)

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