- Uncertainty about peak inflation in the US continues to support the dollar.
- Beijing's zero covid policies add to the greenback's safe-haven appeal.
- Russia's ongoing war in Ukraine gives sterling an advantage over the euro.
- That advantage is undermined by relative certainty about the BOE's policies, differing from the ECB's.
EUR/USD and GBP/USD are set to extend their declines – and for good reasons. Where is the bottom? The low point for these currency pairs heavily depends on the Federal Reserve and the main question is: when will the dollar reach a top?
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US inflation has yet to peak
The top is peak inflation, or better said: core inflation. Once prices of everything excluding volatile food and energy begin stabilizing, the high point in the Fed's tightening cycle would be seen. Currently, the greenback benefits from high uncertainty, which is compounded by other issues (see later).
The Core Consumer Price Index (Core CPI) read came out at 0.6% MoM in April, which is over 7% in annualized terms. The Fed's target is 2%. On a yearly basis, prices rose by 6.2% from April 2021 to the same month this year.
We would need to see at least two months of Core CPI at 0.2% or 0.3% tops in order to be able to say that the peak is behind us. If the rate of underlying price rises stabilizes at around 6-7%, we could call it "cresting" rather than having peaked, and that could slow the dollar's ascent. However, it is significantly different than seeing a peak in the rearview mirror. Cresting does not promise the end of the climbing.
China's covid policies vs. economic reality
The second factor driving the dollar higher is China's handling of covid outbreaks in Beijing and Shanghai. The Communist Party's zero covid policy has already taken a heavy economic toll, as the 11.1% YoY plunge in retail sales and the 2.9% drop in industrial production recorded in April. At some point, China would either have depressed the virus as it hopes or have abandoned its policy.
At this point in time, any loosening is limited and uncertainty boosts the safe-haven dollar. Moreover, lower output by China's factories is adding to supply-chain issues and boosting inflation – fueling the Fed's tightening cycle.
Chinese President Xi Jinping desires his covid zero policy to succeed ahead of the party's all-important Congress in October. He seeks to break with tradition and win a third term, riding on his management in battling the disease. However, if fighting this war costs him high unemployment – it has already climbed to 6.1%, worse than expected – he might have to change course.
While there is no change in Beijing's policies, the dollar would likely remain bid and both EUR/USD and GBP/USD would continue falling.
The war hurts Europe more than the UK
The third factor moving these currency pairs is the war. Russia's invasion of Ukraine has sent prices of oil and gas skyrocketing, hobbling the economies of both the eurozone and the UK. Ongoing hostilities weigh on both underlying currencies – but not equally.
The euro has a disadvantage as Germany's industry heavily depends on Russian energy. It remains the locomotive of the currency bloc. While gas prices are an issue for British households, the UK economy is more dependent on services than energy-guzzling manufacturing.
An end to the war would boost both currencies, but it would be more beneficial to the euro than to the pound. While the war rages on, sterling has the upper hand over the euro, when it comes to the impact of hostilities.
ECB uncertainty vs. BOE relative certainty
The fourth factor is monetary policy. This war-related advantage is currently more than erased by uncertainty about monetary policy.The Bank of England has raised rates to 1%, and has signaled that fears of recession would hold it back from considerable hikes. The pound has already taken a beating for the BOE's indications.
The European Central Bank has yet to increase borrowing costs, and it is hard to tell where it would stop. This uncertainty is positive for the euro in the short term.
However, once the Frankfurt-based institution begins raising rates, concerns over a substantial downturn could hold it back. The ECB would follow the footsteps of the BOE, signaling a halt – without being able to raise interest rates significantly. The Frankfurt-based institution's current deposit rate is at -0.50%. The minus sign means commercial banks are penalized for parking money with the ECB.
Overall, the euro has an advantage over the pound in the short term due to uncertainty about the ECB's policies and significantly more certainty about the BOE's next moves. Once the ECB begins moving, it would already have to stop, sending the common currency down – and that would outweigh any advantage from potential and hopeful end to the war.
Final thoughts
Trying to find a bottom is akin to catching a falling knife. However, understanding these four factors is helpful in understanding the dynamics of EUR/USD and GBP/USD.
