With all the talk about the ongoing Jackson Hole Symposium, the focus has been on the dollar. And with the rate-sensitive 2-year yield continuing lower, the dollar has been dragged down. The index hit a 7-month low. Earlier in the week, it hit an 8-month low against the Euro.
This weakness in the dollar being caused by a recalibration of the growth prospects in the world’s largest economy is masking economic problems elsewhere. Specifically, Europe. The EURUSD is higher on the week, and has been tracking higher through the month. Not because the Euro is stronger, but because the dollar is getting weaker even faster than the Euro. For now.
Time for More Easing
Earlier in the week, ECB’s policymaker representing Finland Olli Rehn heavily implied that easing in September again would be a good idea, especially in light of concerns about European inflation. He specifically addressed the issue of a slowing economy. His comments stand out because he’s typically seen as one of the more hawkish “Northern” members of the ECB.
Last time around, the ECB kept rates unchanged after they started easing in July. That allowed the hawks a bit of a victory, as inflation in the Euro Area remains above target. But, subsequently, economic data has pointed to the downside, which might be giving the advantage to the doves who want at least two if not three rate cuts for the rest of the year. That could put the Euro on a steeper weakening course, and potentially match the dollar as the Fed shows more reluctance to ease than its European counterpart.
Same Old Problem
As the distortions from the pandemic and the war in Ukraine start to wear off, Europe is going back to where it was pre-2020. The one major difference being that energy is even more expensive than before. For well over a decade, the ECB had been fighting a stagnant economy with corresponding slow inflation. This kept interest rates in negative territory through the 2010’s.
Europe appears to be heading in that direction again, but with slightly higher inflation that would make it hard for the ECB to justify taking rates down as far as before. The latest indicators in that direction were the flash August PMIs, which highlighted weakening industrial activity in both France and Germany, amidst ongoing concerns about European inflation. The results were not only below expectations, but below the prior month. Typically, summer is when there is more economic activity, and abundant solar energy reduces the continent’s need for as much energy imports.
So, How Much Cutting to Expect?
Conventional economic theory at the moment is that interest rates have to be above inflation in order to drive down CPI. Before, inflation was below target, so the ECB could cut rates below the interest rate to push up inflation. If inflation is above target, then it puts a floor on how far rates can decline. With June inflation reported at 2.5%, the ECB would have to keep rates above that level even if the EuroZone economy were to tip into the red.
Next week’s inflation data will be pivotal for expectations for the ECB, as the market is expecting inflation to get back to target next year, and allow the ECB to cut by as much as 200bps into 2025. But if European inflation stays high even as the economy slows, then the ECB will be in a bind. And the market might come to start pricing in even more Euro strength.
