This morning, markets received fresh information on growth conditions in Europe and forecasters expectations for inflation.
Both of which help frame yesterday’s ECB decision to hike rates by 50 basis points, which we viewed as an extra level of support for the single currency above the parity threshold as opposed to a bullish driver from current spot levels. This was largely due to the fact that downside risks remained prominent in the EUR outlook. These mainly centre on Europe’s growth profile, which in effect would restrict further policy tightening by the ECB towards year-end. While the largest risk takes the form of gas supplies from Russia, which presents the possibility for EURUSD to structurally break the parity threshold, Europe’s growth profile also sits under pressure from rising uncertainty and price pressures.
This morning’s preliminary PMIs out of France and Germany for July highlight this, with the downturn in manufacturing activity especially notable due to rising concerns over energy security, ongoing difficulties in supply-chains, and a weaker demand outlook.
While services activity in France held strong above the breakeven 50 threshold, in Germany, pressure on household budgets from rising prices continued to weigh on new business for the services sector for the second consecutive month, tipping the measure into contractionary territory. In response to the flash PMIs out of Germany, EURUSD shed nearly three-quarters of a percentage point to sit close to 1% lower on the day as it now trades back below the 1.02 threshold heading into the weekend.
Germany’s composite PMI drops below 50 threshold as manufacturing index nosedives
Although currency markets broadly focused on the downturn in eurozone growth conditions, with the PMIs suggesting that Germany is now in a technical recession, the release of the ECB’s Summary of Professional Forecasters (SPF) for Q3 was instructive for the Governing Council’s next moves.
With the growth window to hike rates closing quickly, and the potential for it to narrow further given renewed gas disruptions, we already expected the ECB to hike by a second consecutive 50 basis points at their September meeting.
The release of the Q3 survey data from the ECB, to which the Governing Council had priority access to, reinforces this view. Not only has the average longer-term inflation expectation drifted further above the ECB’s target, but the skew of expectations has markedly shifted to generate a fatter right-hand tail. This poses increased risks to inflation expectations de-anchoring – a scenario the ECB wished to insure against yesterday by front-loading its hiking cycle with a larger-than-expected rate hike.
Probability-weighted distribution of longer-term inflation expectations exhibits fatter right-hand side tails
The combination of lower growth and heightened risks of inflation expectations de-anchoring suggests to us that the single currency will struggle to return to the 1.035-1.06 range in the coming weeks, barring a substantial dovish shift from the Federal Reserve which we see as unlikely. Instead, speculation over a breach in the parity level is likely to remain, but we continue to think that near-term hawkish expectations of the ECB should support the single currency above this threshold in the scenario of continued uninterrupted gas flows from Russia.
Simon Harvey, Head of FX Analysis