Record EU inflation, EUR/USD at risk of setback

EUR/USD Analysis and Talking Points

  • Eurozone inflation hits new high and supports ECB rate hike scenario
  • EUR/USD Bullish Momentum Blocked, Risk of EUR/USD Pullback

Eurozone inflation hits new high

Eurozone inflation rose to 8.1% in May, from 7.5% and above expectations of 7.7%. The core figure also printed above expectations at 3.8% vs. 3.5% and thus reaffirms the case for ECB tightening in the third quarter. However, the question for the ECB is whether the bank will go ahead with 25 or 50 basis points in July. Although money markets are pricing a 34 basis point tightening in July, a 25 basis point hike is still the base case for me. Along with this, slower growth remains the risk going forward, which in turn still supports the trend to mitigate the declines in the US Dollar.

DailyFX Calendar

Source: DailyFX

Corrective price action on EUR/USD has seen the pair rally towards the 38.2% Fibonacci retracement of the 2022 range. However, momentum appears to be stalling around the 1.0750-80 region, which offers Euro bears an area to seek a pullback for the currency. Bear in mind that EU leaders agreeing to a partial oil embargo on Russia will block 2/3 of Russian oil imports, ultimately weigh on EU growth prospects in the future and, by extension , will put pressure on the euro.

The Euro’s current rally is around 4% from its recent lows, compared to previous rallies of 3.3-3.5% in January and March, which signals to me that the current bounce is perhaps be a bit long in the tooth. While last week’s comments from the Fed’s Bostic regarding a potential pause in tightening as early as September likely exacerbated dollar weakness, the Fed will be loath to walk away from its aggressive tightening outlook given that inflation remains very sticky at extremely high levels.

EUR/USD chart: daily period

EUR/USD outlook: Record EU inflation, EUR/USD at risk of setback

Source: Refinitiv

FINAL WORD: End of Month Rebalancing

As a reminder, today is the end of the month and therefore currency rebalancing may result in some noisy price action as we head into the 4pm fix in London. Currently, investment banking models are reporting net sales of USD.

FX MONTH-END REBALANCING EXPLAINED

London WMR correction (1600 London time): The WMR Fix is ​​one of the most widely used benchmarks for FX trading, taking place daily in a 5 minute window around 1600 London time. The patch provides a standard set of benchmark currency rates so stock and bond investors can compare portfolio valuations and performance with each other.

The WMR patch tends to coincide with a large increase in trading volume, leading to a large increase in liquidity. Sometimes this allows large real money flows to take place without causing too much distortion. However, flows can also be dominant in one direction (strong buying or strong selling) leading to outsized moves in a very short time.

The biggest bout of volatility comes from the month-end patch, which takes place on the last business day, where extreme market moves can often occur upstream between 3:00 p.m. and 4:00 p.m. London time. These foreign exchange flows come primarily from equity rebalancing.

Thus, if a UK portfolio manager holds assets denominated in US dollars and seeks to hedge currency risk, a monthly increase in the value of those assets will lead to more dollar hedging (selling of dollars). For example, if stocks are currency hedged and US stocks (S&P 500) rose during the month, while the FTSE 100 (UK stock market) traded flat, UK-based investors Uni would sell US dollars against the pound to add to their hedge. , leading to an appreciation of the GBP/USD. The greater the outperformance of the US stock market against the UK, the more the dollar would sell the USD against the pound, which would encourage the pound to rise even higher. However, extreme movements can often partially return the day after the month-end patch. That said, the occurrence of such an event in a market as liquid as FX suggests that the London fix (month-end fix in particular) is an important one for FX traders to watch.

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