One of the key terms already dominating the news flow this year is reflation. Price action this week has provided a key insight into how FX markets trade during the time of reflation. Soaring global PMIs, surging industrial commodities plus stronger German and EuroZone inflation have all combined to undermine EUR which has been weighed on over the first trading day of the year.
Currency Not Responding To Better Inflation Data
A weakening currency during times of rising inflation reflects the level of skepticism in the market regarding the central bank’s credibility. When central banks are deemed Hawkish, then positive inflation readings tend to immediately push FX prices higher, fuelled by increasingly supportive nominal interest rate differentials. However, when the central bank is deemed Dovish, then it is not the nominal interest rate differentials that determine the market response but instead the real interest rate differentials.  Indeed, Wednesday’s rally in the EURUSD can be viewed more as a function of the Dollar weakening ahead of the FOMC minutes, rather than a rally on positive inflation data.
Inflation data released on Wednesday showed that core inflation rose to 0.9% in December, above estimates of 0.8% whilst headline inflation rose to 1.1% over the same periods, above estimates of 1%.
Dovish ECB Framework
The ECB has clearly established a Dovish framework, and in the context of EMU divergence pressures increasing, they have little choice other than to apply a policy for the weakest relevant link. Put simply, a booming Germany with inflation rising quickly against the ECB’s target of 2% doesn’t in fact support a higher EUR rate. In fact, the combination of rising inflation and a Dovish ECB framework is weighing on real rates, especially the short end of the curve which translates directly into EUR selling pressure.
EUR Trading Like JPY
EUR is currently trading in a similar fashion to how JPY did last autumn. The BOJ had established their Dovish framework by announcing their intention to manage the yield curve. During a period of global reflation, this essentially equaled a call for lower real rates and yields. Indeed, since the September BOJ meeting, JPY real yields have fallen the most within the G10 space, forcing JPY lower.
