• Careers FAQs Client login
Stimulus, policy divergence and inflationStimulus, policy divergence and inflationStimulus, policy divergence and inflationStimulus, policy divergence and inflation
  • Home
  • Services
    • Foreign Currency Risk Management
    • Interest Rate Risk Management
    • Fund Finance Services
    • Investment Products
  • Industries
  • Our Technology
  • About
    • Who we are
    • Culture
    • Careers
  • Our Team
  • News & Insights
CONTACT US
✕
            No results See all results
            Can the FX and Rates markets both be right?
            14 July 2021
            Will the BoE beat the Fed in the race to raise interest rates?
            3 August 2021
            20 July 2021
            Categories
            • Insights
            Tags
            INSIGHT • 20 July 2021

            Stimulus, policy divergence and inflation

            author-ali-jaffari

            Ali Jaffari, Head of North American Capital Markets


            With an ever-evolving economic environment, major central banks take on the rigorous task of reviewing their strategy and adjusting the policy framework periodically. For the Fed and the Bank of Canada (BoC), for example, this review typically takes place every 5 years. The European Central Bank (ECB) last completed its review in 2003, and almost two decades later, it recently released the results of an 18-month monetary policy strategy review. The outcome of it? Not as impactful as one would expect.

            In an effort to provide further clarity, the ECB revised its inflation target to be more in line with global benchmarking at a flat 2% level. Unlike the Fed’s 2% averaging target, which allows for inflation overshoots (look at the last two US inflation prints at 5% and over), the ECB does not seem accommodating of deviations outside its objective, at least not longer-term. With the strategy review now complete and a new target inflation level established, it will be interesting to see how the ECB adjusts its forward guidance at the upcoming policy meeting.

            Following the shift in rhetoric from the Fed last month, major central banks around the world have been active in discussions or acting on taper strategies as seen by the BoC, Reserve Bank of New Zealand, Reserve Bank of Australia, and Norges Bank. The ECB however was quick to dismiss any accordance to this path and went to great lengths to highlight the differences between the regions.

            With that said, and the ECB now revising its inflation target, there is further latitude for the central bank to ramp up its pandemic related asset purchases to stimulate activity in a region that has struggled with low inflation levels over the years. This could potentially result in continued accommodative policy measures beyond the set expiry of the Pandemic Emergency Purchase Program (PEPP) in the spring of 2022. In that event, policy divergence with the other central banks will continue to drift apart and lead to further declines in the Euro.

            There has been a decent sell off in EUR in recent weeks, and we have seen net long positioning pare back (see Chart 1). The market looks towards the upcoming ECB meeting on July 22 and will assess the impact of its new policy strategy and how it weighs on forward guidance. In order to support the new inflation mandate, I would expect a dovish tone from the ECB along with a commitment to holding / extending its policy. It is fair to say that further monetary stimulus may also be required to support the higher inflation target, and the market will look for an indication from the ECB on the size of its asset purchases going forward.

            Chart 1: EUR/USD (top) vs Net Euro Positioning (bottom)

            stimulus policy graph 1

            Source: Bloomberg

            Despite the most recent eurozone inflation print hovering just one tick below 2%, policy makers are brushing aside the price pickup as temporary and continue to focus on high unemployment levels signalling a somewhat weak medium-term outlook. It seems to me that the ECB is treading lightly here to avoid tipping off the market and ward off any tightening discussions until the data proves otherwise. Erring on the side of caution is likely a lesson learnt from its past actions – think back to 2011, when the ECB impulsively hiked rates on what was only a temporary spike in inflation.

            EUR positioning has reversed since the June FOMC meeting and short positions are starting to build (see Chart 1). In the short-term, expect this momentum to persist as the ECB continues to lag behind other G10 central banks in terms of policy and its rate hike outlook. With EUR/USD extending its downtrend, it seems well set to test its YTD lows at 1.1717 (this is the next area of support for the pair). This range is consistent with our ‘Market Melt-Up’ scenario, which prices in aggressive Fed action and growing policy divergence.

            Longer-term however, we have highlighted the risk that despite the shift in the Fed’s rhetoric, the likelihood of the Fed ‘walking the talk’ is growing increasingly unlikely. Inaction from the Fed, along with inflation running hot (as seen by June’s YoY CPI print of 5.4%) would result in a reversal of the recent month’s price action and a rally in the EUR/USD pair. Our 2021 FX outlook, highlights just this under the ‘Market Melt-Up’ scenario which looks at currency implications pre and post action from the Fed as a result of spiralling inflation.

            Ahead of next week’s ECB announcement, keep a close watch on how the central bank looks to incorporate its revised inflation target into its policy measures. Expect there to be talks on additional stimulus requirements and perhaps an extension to the PEPP to support the new target. Continued dovishness from the ECB will pave the way for increased policy divergence in the near-term and weigh on the Euro.

            Be the first to know

            Subscribe to our newsletter to receive exclusive Validus Insights and industry updates.

              Share

              Related posts

              2 June 2023

              Reviving Concerns: Central Banks and Inflation Regain the Spotlight


              Read more
              31 May 2023

              The market meets (the Fed’s) expectations


              Read more
              24 May 2023

              Will the labour market be the answer to the MPC’s prayers?


              Read more
              Validus-white-logo
              Services

              Foreign Currency Risk Management

              Interest Rate Risk Management

              Fund Financy Advisory

              Investment Products

              Industries

              Private Capital

              Pensions Funds

              Corporates

              Our Technology

              RiskView

              TradeView

              PortfolioView

              London

              19 Wells Street
              London W1T 3PQ
              T. +44 (0) 203 923 8575

              Eton, UK

              119-120 High Street
              Eton, SL4 6AN
              T. +44 (0) 175 338 6548

              Toronto, Canada

              10 King Street East, Suite 800
              Toronto, Ontario M5C 1C3
              T. +(1) 416 646 0590

              New York, United States

              222 Broadway, 19th Floor
              New York, NY 10038
              T. + 1 929-219-3793

              T&Cs | Privacy Policy | Regulatory

              Copyright 2022. All rights reserved. Validus Risk Management Limited is authorised and regulated by the Financial Conduct Authority (firm reference 555972), is licensed by the CFTC and is a member of the NFA (ID 0504990). Validus Risk Management Limited is incorporated in England and Wales (registration number 07140753), with its registered office at 119-120 High Street, Eton, Windsor, Berkshire, SL4 6AN, United Kingdom.

              CONTACT US
                        No results See all results