Fate of the single currency to be decided by forthcoming ECB meeting
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Earlier this year, the ECB announced their intentions to wind down their asset purchasing program by the end of 2018. These comments contributed to the growth of the single currency, as many investors bet that more decisive steps would be taken towards the further tightening of monetary policy. While the economy continues to grow, there is increasing evidence that the ECB can take a more cautious approach.
In March, signs that economic growth was decelerating began to appear. The Purchasing Managers Index (PMI) data - a good leading indicator for business activity - for February and March registered a decrease from multi-year highs, to levels last seen at the beginning of 2017. The latest Composite PMI reading of 55 still indicates economic growth, albeit at a slower pace than previously.
It is very important for the ECB to raise inflation closer to 2% as a sign of economic health. However, other than a brief touch of this level at the beginning of 2017, price growth has only decelerated. The latest data indicates inflation of 1.3% YoY, lower than November's 1.5%. Core inflation, excluding food and energy, is stable at 1% - 50% lower than the ECB's goal of 2%.
Weak inflation and slowing economic growth are, to a large extent, caused by the current strength of the single currency. Over the past year, it has grown 18% against the U.S. dollar, acting as a powerful headwind and limiting the Eurozone's economic growth.
The weakening of the single currency between 2011 and early 2017 led to a growth in the foreign trade balance, from near zero to a monthly average of 20 billion. In the last year, however, the growth of this indicator has stalled. The impressive growth of the global economy throughout 2017 helped to boost this trade surplus. The acceleration of the Chinese and U.S. economies had raised demand for European goods, but now this demand seems to have been exhausted.
Despite the perennial lows in the unemployment rate, and the impressive growth rates of the economy, the ECB is unlikely to rely on strong domestic demand as a driver for inflation. Retail PMI is currently near 50, reflecting the balance between a slight downturn and growth. The retail sales index, while demonstrating growth YoY, has slowed since the middle of 2017.
The Eurozone's unemployment rate currently sits at an impressive 8.5%, the lowest level in 10 years. However, as can be seen in Britain, the United States and Japan, even the lowest unemployment rates in 20-40 years are not enough to positively influence wage growth and consumer prices.
It may be a suitable strategy for Draghi to reassure the markets that the bank acts on the basis of data and that this data does not yet indicate that the rapid growth of inflation should be feared.
If this happens, the common currency is likely to fall under pressure due to the expectations for a rapid winding down of incentives and a quick increase in rates by 2019. As a result, the pair may quickly lose support and fall from the current highs near 1.24 to the 1.20 level.
Assurances that it is the economy that stands in the way of impressive growth, coupled with confident forecasts for future growth, will likely help the euro, pushing the EURUSD pair out of consolidation and up to new highs. If this is the case, the pair will be able to quickly reach the important level of 1.30.
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