Fundamental Analysis EUR: ECB Rate Cut Eyed as Eurozone Inflation Cools, Traders Brace for US Jobs Data
Sunday, 2 June 2024, Week 22: This report provides a comprehensive analysis of the market fundamentals currently affecting the euro (EUR). It examines fiscal policy, economic indicators, and monetary policy developments within the Euro Area, assessing their potential impact on the EUR. The report analyses the factors that have influenced EUR movements over the past five months and five weeks, and evaluates the potential influences on the currency in the coming five months and five weeks. The report concludes with a summary of key findings and a list of referenced sources.
The Euro Area economy is exhibiting signs of recovery, with positive GDP growth and a strong labour market. However, persistent core inflation and the potential impact of tighter monetary policy present ongoing challenges.
FISCAL POLICY
The Euro Area's fiscal policy is gradually tightening as governments grapple with high debt levels. Eurostat data reveals that the Euro Area government debt to GDP ratio decreased from 90.8% at the end of 2022 to 88.6% at the end of 2023. However, Trading Economics forecasts this figure to rise to 89.4% by the end of 2024 and then to 89.2% in 2025. The government deficit to GDP ratio also declined from 3.7% in 2022 to 3.6% in 2023, although eleven Member States still exceeded the 3% limit set by the Stability and Growth Pact. This suggests that while progress is being made, maintaining fiscal discipline remains crucial for the Euro Area's long-term stability.
ECONOMIC OVERVIEW
The Euro Area economy expanded by 0.3% in the first quarter of 2024, recovering from two consecutive quarters of contraction. This growth aligns with expectations and suggests that the Eurozone is on a path to recovery. The European Commission forecasts 0.8% growth for 2024, driven by consumer spending and improved trade. However, softening investment growth poses a potential downside risk.
The labour market continues to demonstrate resilience, with unemployment reaching a record low of 6.4% in April 2024. This positive development, coupled with steady employment growth, indicates a healthy demand for labour. However, the potential impact of wage growth on inflation requires careful monitoring. Wages in the Eurozone rose by 3.1% year-on-year in the fourth quarter of 2023, the slowest growth rate since the third quarter of 2022.
Inflation in the Euro Area has shown signs of easing in recent months, but a recent uptick in May 2024 warrants close monitoring. Preliminary estimates from Eurostat show that the annual inflation rate rose to 2.6% in May 2024, up from 2.4% in the previous two months. The rebound in energy prices and faster growth in services prices contributed to this increase. However, core inflation, excluding energy and food, also rose to 2.9% from 2.7%, surpassing expectations.
MONETARY POLICY
The European Central Bank (ECB) maintained interest rates at record-high levels for a fifth consecutive time during its April meeting, with the main refinancing operations rate remaining unchanged at 4.5%. The ECB acknowledged that inflation has continued to decline but cautioned that domestic price pressures remain strong. The ECB staff macroeconomic projections for the euro area, published in March 2024, suggested that euro area inflation is set to fall faster than previously expected and hit 2.1% in 2025. However, the report also noted upside risks to inflation, including heightened geopolitical tensions.
The Governing Council’s decision to leave interest rates unchanged in April suggests that it sees inflation risks as broadly balanced. However, the central bank’s indication that it may consider reducing the level of policy restriction suggests that it is becoming more confident that inflation is on track to return to its 2% target in a timely manner.
LOOKING-BACK
Five-Month Influences: Over the past five months, the EUR has appreciated against the USD, driven by several factors:
Shifting Interest Rate Differentials: While the Federal Reserve embarked on an aggressive rate hiking cycle, the ECB maintained a more cautious approach. This divergence in monetary policy initially favoured the USD. However, as the Fed signalled a potential pause in its rate hikes and the ECB maintained its tightening bias, the interest rate differential narrowed, supporting the EUR.
Eurozone Economic Resilience: Despite facing numerous headwinds, the Eurozone economy has proven more resilient than initially anticipated. The better-than-expected economic data, particularly regarding GDP growth and the labour market, has bolstered the EUR.
Weakening USD Sentiment: The USD has faced headwinds due to concerns about the US economic outlook and the potential for a less hawkish Fed. This shift in sentiment has benefited the EUR, particularly as investors sought alternatives to the USD.
Five-Week Influences: In the past five weeks, the EUR has continued to strengthen against the USD, primarily driven by:
Easing US Inflation Concerns: The release of the US core PCE inflation data for April, which met expectations, eased concerns about an overly hawkish Federal Reserve. This data increased market expectations for a Fed rate cut later this year, diminishing the USD's appeal and supporting the EUR.
Surprise BoJ Policy Shift: The Bank of Japan's decision to cut the amount of JGBs it offered to buy in a regular operation spurred bets on potential quantitative tightening in the future. This move strengthened the Japanese yen against the USD, indirectly supporting the EUR as well.
ECB Rate Cut Expectations: Market expectations for an ECB rate cut in June have been rising, particularly after the release of softer-than-expected Eurozone inflation data. These expectations have contributed to the EUR's recent strength.
LATEST and LOOKING-AHEAD
Five-Month Potential Influences: Looking ahead, the following factors are likely to influence the EUR:
ECB Monetary Policy: The ECB's upcoming interest rate decisions will be crucial for the EUR. A rate cut in June, as widely anticipated by the market, could limit the EUR's upside potential. However, the central bank's communication regarding its future policy path will be equally important. A more hawkish than expected stance, emphasizing the need to combat inflation despite slowing growth, could provide support for the EUR.
Eurozone Economic Outlook: The trajectory of the Eurozone economy will also be a key driver for the EUR. While recent data has been positive, the ongoing energy crisis, the war in Ukraine, and slowing global growth pose significant downside risks. Any deterioration in the economic outlook could weigh on the EUR.
US Economic Performance: The relative strength of the US economy compared to the Eurozone will continue to influence the EUR/USD exchange rate. A sharper-than-expected slowdown in the US economy could weaken the USD and support the EUR. Conversely, a robust US economic performance could strengthen the USD and weigh on the EUR.
Five-Week Potential Influences: In the next five weeks, the EUR could be influenced by:
ECB Interest Rate Decision (June 6th): The ECB's interest rate decision on Thursday, June 6th, will be the most significant event for the EUR in the coming weeks. A 25 basis point rate cut is widely anticipated by the market. However, the focus will be on the ECB's communication regarding its future policy path. A more hawkish than expected statement, emphasizing the need to combat inflation despite slowing growth, could trigger a relief rally in the EUR. Conversely, a dovish statement, suggesting further rate cuts are likely, could weigh on the EUR.
US Nonfarm Payrolls Report (June 7th): The US Nonfarm Payrolls report for May, due on Friday, June 7th, will be a key data point for assessing the health of the US labour market. A strong report, indicating continued tightness in the labour market, could reignite Fed hawkishness, potentially boosting the USD and weighing on the EUR. Conversely, a weak report could increase expectations for a Fed rate cut, potentially weakening the USD and supporting the EUR.
CONCLUSION
The EUR has been on an appreciating trend against the USD over the past five months, driven by shifting interest rate differentials, Eurozone economic resilience, and weakening USD sentiment. While the ECB is widely expected to cut interest rates in June, the central bank's communication regarding its future policy path will be crucial for the EUR's trajectory. A more hawkish than expected stance could provide support for the currency. Looking ahead, the EUR's performance will depend on the ECB's monetary policy decisions, the Eurozone's economic outlook, and the relative strength of the US economy.
Referenced Sources:
Eurostat
European Central Bank
Federal Reserve
U.S. Bureau of Economic Analysis
U.S. Bureau of Labor Statistics
Reuters
Trading Economics