Mid-week note: the ECB’s conundrum, how China factors into the equation and an NFP preview

The euro dropped sharply on Thursday as traders digested economic data that was positive for the US and negative for the Eurozone. In the Eurozone inflation is rising at a more rapid rate than had been expected, for example, in France, the monthly rate of CPI rose by 1.1%, pushing the annual rate up from 5.4% in July to 5.7% in August. Combined with the sharp slump in German retail sales, which fell 0.8% on the month in July, and fears about stagflation are starting to weigh on the single currency. The question now is, how long will the dollar recovery continue and can stocks keep up their first weekly rally since June?

The ECB has a difficult decision to make

The next ECB meeting on 14th September has taken on a new level of significance after the CPI reading for August. The harmonised Eurozone rate of CPI growth rose by 0.6%, expectations were for a 0.1% decline, while the annual rate rose to 5.3% from 5.1%. This is still well above the ECB’s 2% inflation target, and since they are a central bank with a single mandate – that of ensuring price stability – the pressure is on the ECB not to ignore or look through this inflation print. However, is there an argument to be made that disinflationary forces are still in play, and that this is a mere stumble on the road to bringing price growth back under control? Those who argue that inflation is already well under control cite core inflation, which fell as expected to 5.3% from 5.5%, as signs that underlying price pressures are moderating. However, survey results from last week suggest that inflation expectations are creeping higher again, which is another cause of concern for the ECB. The ECB is split down the middle between hawks – with Austria and Germany some of the most vociferous in favour of more hikes to bring down price pressures, and the doves, who mainly come from the South, and are keen to stress the threat to growth, and their more highly indebted economies, from rising interest rates. Christine Lagarde has towed a finer line, showing no tolerance for inflation, but also sounding concerned about the outlook for growth. Right now, there is a 30% chance of a rate hike from the ECB next month, which has fallen on Thursday as the market focussed on the decline in core inflation as a signal that the ECB will pause when they meet on Sept 14th.

Reasons to pause

Although the Eurozone’s inflation rate is 2.5 times the ECB’s target rate, we think that there is a growing case for the ECB to pause when they next meet. This is down to three reasons: 1, survey data is often a small sample size and thus a rise in consumer inflation expectations cannot be relied on. 2, service sector inflation moderated in August, even though it was peak summer and tourist season. Thus, the strongest inflation pressures for most of 2023 are finally starting to recede. Although energy prices lifted the August CPI figures, they can be volatile as we lead into the Autumn. 3, China’s malaise is starting to weigh on growth across the continent, especially Germany. Trade between Germany and China stalled in Q2, and Hamburg’s port saw a steep decline in shipping volume and a significant decrease in revenue, which does not bode well for future growth. Thus, when your economic engine is faltering, it could be time for the ECB to hit pause on the rate hikes.

Upward momentum on the dollar’s side

The inflation data was not the only piece of economic data that weighed on EUR/USD on Thursday, which fell more than 0.7%, however, $1.0800 is holding as decent support so far, as we lead up to Friday’s NFP report. However, there is no doubting that the economic data in the US is looking perkier than across the Atlantic in Europe, which could give the USD another lease of life as we move into September. Upward momentum appears to be on the dollar’s side, it rose 1.67% on a broad basis in August. As mentioned, the economic data could also be more supportive of the buck in the coming weeks. The pressure could be on the Fed to continue to hike rates after personal spending rose by 0.8% in July, which is a healthy clip for a monthly rate. Added to this, Core CPE, the Fed’s preferred measure of inflation, has stalled around 4.2% YoY, which is likely to be too high for the Fed’s liking. While there is an 88% chance that the Fed will pause when they meet in September, expectations of a 25bp rate rise by December have been rising. There is now a 35% chance of interest rates rising to 5.5-5.75% by year end, that is up from a 25% chance a month ago. If this trend continues, then we could see further dollar gains across the G10 FX space.

NFPs – to be taken with a pinch of salt

Elsewhere, the outcome of Friday’s NFP report will also be parsed to see what the Fed will do next. We would point out that some savvy analysts have noted that responses to the NFP survey is trending lower, which makes the US jobs report a less reliable indicator of the US economy. However, at 1330 BST on Friday the market will be focussed on NFPs. The market is looking for a reading of 170k for payrolls for August, average hourly earnings are expected to remain at 4.4% and the unemployment rate is also expected to stay steady at 3.5%. Thus, aside from the headline number, this report may not cause too many fireworks, which could leave the dollar, and US stocks, able to carry on their mild trajectory higher. We would point out that average annual wages are also misleading, for example, if lower paid workers are seeing their pay packet fall, it doesn’t show through in the data if middle and higher earners help to keep the average stable. Thus, it’s worth looking at the NFP report to see where the job losses are targeted, and how this could impact the US consumer. As more people are fretting about a US recession, there are signs that the lowest earners are struggling more than other cohorts.