Germany and the Eurozone

Discussion and Analysis by Charles Porter:

Accounting for a little over one fifth of total the European Union’s GDP, the systemic significance of Germany to the single currency is hard to overstate. Of the series of hard economic data that affect currency markets strongly, the Consumer Price Index (CPI) measure of inflation is certainly towards the top of the list. Therefore, this afternoon’s inflation data registered strongly throughout the single currency. Whilst volatility is low and markets appear ambivalent to most events, the release registered shy of a 0.2% change in the value of the Euro.

The stability of the European system is certainly where the Euro derives considerable value. As such, when it is disrupted, there can be considerable shocks to the value of the single currency. However, just as an independent, floating, currency is affected by idiosyncratic national data, so too is the Euro. Albeit to a lesser extent and perhaps muted, any salient data at the national level should be perceptible at the Eurozone level.

Consumer Price Index (CPI) inflation data for October was recorded at 1.6%, inferior to the previous year-on-year recording of 1.8%. Of particular importance to the strength of the Euro, the fall of 0.2% was unanticipated, meaning that the majority of the fluctuation was not already priced the market. This fact invited a selling-off of Euros while the inflation rate, aggregate economy and probability of and interest rate hike were re-evaluated.

The inflation rate is of particular importance to the exchange rate because it is the target of monetary policy. This week’s theme is undoubtedly monetary policy and interest rates. With several of the world’s key central banks meeting this week to decide the path of monetary policy, global bond, currency and equity markets could truly be reshaped this week. Bucking the trend, the European Central Bank (ECB) has already met and, last week, decided to taper the asset purchase programme of quantitative easing by €30bn per month commencing in 2018 from its present volume of €60bn per month.

The ECB’s dovish decision, including the possibility for a re-scaling of the asset purchase program and the guaranteed sustainment of reinvestment for maturing assets, sent the Euro down against its counterparts including the Dollar and Pound Sterling. Today’s announcement within the Eurozone’s major economy, Germany, made the probability of further Dovish central bank policy higher, at least for the immediate future. The release similarly foreboded wider Eurozone CPI inflation statistics that are due to be released tomorrow.

With employment pushing up and the economy close to, if not at, the natural rate of unemployment, inflation is expected to push up. If it continues to be subdued, following the spate of structural reforms in response to the European sovereign debt crisis, uncertainty will build. If the economy does not begin to behave normally, including the re-normalisation of the Phillips Curve, then market confidence in future and predictable performance will result in gradual risk-off strategies as investors hedge against risk.

The rise in inflation would justify the turn towards monetary policy normalisation that central banks including the Fed, Bank of England and ECB all appear to be preferring or have already taken. The confidence effect of a monetary policy normalisation would end the stagnation of crisis-time regulation and finally signal the return of prosperity and investment. Whilst the data release still only directly concerns Germany, as a single currency-leading economy, investors do trust it as a market leading nation.

The pricing out of any confidence effect alongside the pricing out of some of the probability of a rate hike led to the aforementioned depreciation of the Euro. With Germany painting a bleak picture of the probability of monetary policy normalisation and economic adjustment, we look ahead to the Eurozone data-heavy day tomorrow. Today’s German CPI reading stands in contrast to this morning’s soft data and confidence release. The bias that currency markets place towards hard vs. soft data is useful to elucidating underlying market confidence and sentiment.

The graph above depicts the spike devaluation of the Euro within the Euro-Dollar exchange rate during the statistics release event. Amounting to just shy of 0.2%, the episode represents a repricing of Eurozone-wide inflation, due to be released tomorrow, and the associated rate hike probabilities.