Inflation >9% saw the ECB hike rates 75bsp at their Sep meeting, with post ECB sources saying the bank is planning to discuss Quantitative Tightening at the Oct meeting. It seems like President Lagarde learnt from here July mistakes by being very careful not to give any clues away on where the ECB thinks the terminal or neutral rate is. On spread fragmentation, the bank didn’t provide any new info or clarity on how the eligibility might impact countries like Italy and Spain. Until the BTP/Bund spread breaches 2.55%, markets will have to wait and see whether TPI can make a difference. The main driver for the EUR is the economic outlook, but there are a few different conflicting drivers. Gas supply from Russia remain closed, but energy reform plans have seen EU gas prices lose a lot of ground. The war in Ukraine remains a risk, but recent victories by Ukraine has been a positive development.
POSSIBLE BULLISH SURPRISES
De-escalation or cease fire in Ukraine. Stagflation risks remains, but with lots of bad news priced any materially better-than-expected data could spark some relief (incoming S&P Global Flash PMIs will be very important) Any TPI comments that convinces markets it can solve spread fragmentation issues should be supportive for the EUR. Resumption of Nord Stream gas flows or if gas storage can see Europe through winter, would ease some of the pressure. Given the EUR’s high weighting in the DXY, a dovish FOMC reaction in the USD should be supportive for the EUR.
POSSIBLE BEARISH SURPRISES
Escalation in Ukraine war that risks NATO involvement. Stagflation risks remains, even with lots of bad news priced any materially worse-than-expected data could see more pressure (incoming S&P Global Flash PMIs will be very important) If ECB fails to act on the TPI when we see big jolts higher in the BTP/Bund spread could trigger bearish reactions in the EUR. Announcements that Europe gas storage won’t make it through the winter without resumption of gas flows. Given the EUR’s high weighting in the DXY, a hawkish FOMC reaction in the USD should pressure the EUR.
BIGGER PICTURE
The fundamental outlook remains bearish with recent leading indicators pointing to a much faster economic slowdown than markets previously expected. The current bearish drivers (geopolitics, stagflation, spread fragmentation, energy supply concerns) outweigh the positives. But recent price action suggests that the energy reforms, progress in Ukraine and the push lower in European gas futures has been enough to stop the bleeding for now. Recession risks remain and means incoming data like this week’s S&P Global Flash PMIs will be watched closely. For now, the focus for the EUR is on multiple fronts from energy to policy to geopolitics.
USD
FUNDAMENTAL OUTLOOK: BULLISH
BASELINE
With headline CPI above 8%, the Fed is under pressure to continue hiking rates and ramping up QT to try and equalize supply and demand . They hiked rates 75bsp in July, and after the strong Aug CPI , another 75bsp hike is fully priced and question for the FOMC meeting this week is whether they hike 100bsp. Recent Fed communication pushed back against rate cuts in 2023 and stressed that rates could reach close to 4% in early 2023 and stay there throughout 2023. In July, the Fed announced a data-dependent (meeting-by-meeting) policy stance, explaining that the pace of hikes is likely to slow as rates get more restrictive and more data becomes available. This means incoming growth, inflation and jobs data remains key drivers for short-term USD price action where we expect a cyclical reaction to incoming data (good data being good for the USD and US10Y and bad data being bad for the USD and US10Y ). The Aug CPI print saw markets pricing out the likelihood of a soft landing. This saw further downside in bonds and equities and upside in the USD. However, this narrative is still in focus for many market participants. So, if incoming data continues to suggest that a soft landing is possible, we expect that to pressure the USD. But we’ll let the data guide us.
POSSIBLE BULLISH SURPRISES
With the Fed signalling a data dependent policy stance, we expect a cyclical reaction from the USD with incoming US data. Thus, extremely good growth, inflation or jobs data is expected to trigger short-term bullish reactions in the USD. If the cyclical outlook continues to weaken, the USD’s safe haven status still matters. Any incoming data that exacerbates fears of a deep recession and triggers strong moves lower in risk assets & bonds can trigger safe haven flows into the USD. The Aug CPI saw markets price in a higher terminal rate for the current Fed cycle, which means a lot is already priced going into the FOMC decision. However, should the Fed bring out the big guns and the Dot Plot median for 2023 is closer to 5% or they hike 100bsp, that could trigger further USD upside.
POSSIBLE BEARISH SURPRISES
With the Fed signalling a data dependent policy stance, we expect a cyclical reaction from the USD with incoming US data. Thus, extremely bad growth, inflation or jobs data is expected to trigger short-term bearish reactions in the USD. With some growing expectations of a possible ‘soft landing’ for the US economy surfacing, further goldilocks data (higher growth & labour but lower inflation ) could trigger safe haven outflows from the USD and into US equities. With a lot priced in for the Fed and the USD, it won’t take much to disappoint on the dovish side this week with their FOMC decision. If the dot plot does not exceed what is already priced for the curve or the Fed sticks to a 75bsp hike, it could trigger some sell-the-fact reactions to the downside for the USD.
BIGGER PICTURE
The fundamental outlook for the USD remains bullish as long as the Fed stays hawkish and cyclical concerns put pressure on risk assets. But the data dependent stance from the Fed means that short-term data surprises can pull the USD either way. The recent string of data has triggered some ‘soft landing’ expectations for the US economy, which is expected to weigh on the USD given all of the safe haven inflows based on recession fears. This makes incoming data even more important. Going into the FOMC, there is already a lot priced for the on the rate side and markets are preparing for a very hawkish message. That does increase the risk of a sell-the-fact reaction.
The Eurozone is destined for a hellish winter. Highest inflation reading at 9.1%, and with the energy crisis looming during winter, it's expected that Europe will suffer a severe recession. One could forecast riots, protests, and lawlessness due to lack of oil/gas, people freezing and joblessness continuing to tick up.