ECB Hawkish Pushback to Face Key Inflation Test

The ECB hawks have stepped in to revive depressed rate expectations, but markets are opting for data dependency, and EUR/USD is set to face two key risk events with eurozone inflation figures before the US payrolls this week. I expect core inflation will prove resilient enough to trigger another ECB hike, so see upside room for the pair. 

USD: Things will get hectic this week.The FX markets began the week with a sluggish pace. Trading activity was subdued due to the UK's markets being closed for a national holiday on Monday, leading to lower trading volumes. The economic calendar lacked significant key data releases. In the US, the noteworthy data release was the Dallas Fed Manufacturing Index. It declined more than anticipated, entering contraction territory. This confirmed the existing indication of manufacturing slack from other surveys such as ISM and PMIs. Nevertheless, the slowdown in manufacturing is not limited to the US alone. Numerous developed economies, notably Europe, have experienced a decline in forward-looking economic indicators.

What sets the current situation apart is the relative resilience of the US service sector compared to the eurozone's, despite the US adopting a considerably tighter monetary policy. This contrast in activity indicators, coupled with exceeding expectations, has maintained demand for the dollar in recent weeks. It's likely to remain the primary driving force behind USD movements heading towards the end of the year. This is primarily due to the strengthening disinflationary trend, enabling the Fed to pause interest rate hikes and shift its focus to economic growth. As long as data remains positive, markets won't factor in further rate cuts. Additionally, the favourable real interest rate, the highest among the G10 countries, will provide support for the dollar.

The upcoming week carries notable risk events that could impact the dollar's trajectory. Last night we had the JOLTS job openings report for July, which reveals signs of a more pronounced cooling off in the labour market. The Conference Board Consumer Confidence Index is also set to be published, with expectations of marginal change compared to July. Later in the week, the ADP jobs numbers and the official payrolls report are scheduled for release. It's important to note that payrolls data for March was preliminarily revised downward by 306,000, which could add to the significance of this week's release.

Currently, the DXY is hovering around the 103.50 high range seen in May and June. Investors might prefer to await confirmation from jobs data before making significant moves to drive the dollar higher from these levels. A wait-and-see approach could dominate the FX markets leading into Friday's payrolls report.

EUR: Gearing up for the inflation test.As the upcoming September policy meeting of the ECB approaches, it's unsurprising to witness the emergence of ECB hawks advocating for a more stringent stance. The issue that seems to be concerning the more hawkish members of the Governing Council is the market's perception of the September meeting. The market's reluctance to fully factor in a final ECB rate hike has kept the implied probability of a September move below 50%. Despite statements from Governing Council member Robert Holzmann indicating a strong likelihood of rate increases, the market's response has been limited. Even President Christine Lagarde's tone during her recent Jackson Hole speech leaned towards the hawkish side. She seemed to downplay the growing evidence of a swift deceleration in the eurozone's economy, emphasizing the importance of staying aligned with data-driven decisions.

Interestingly, it's evident that the markets are embracing the ECB policymakers' data-dependent approach, which is somewhat uncommon. The market is awaiting this week's inflation data releases to make a final determination regarding the likelihood of a September rate hike. Here's a timeline for this week's inflation data releases: German data is scheduled for tomorrow morning, alongside Spain's figures. Subsequently, on Thursday, French, Italian, and eurozone-wide inflation figures are set to be released.

The consensus among economists is that core CPI inflation will moderate from 5.5% to 5.3%. However, ING economists predict a rate of 5.4%. This slight difference could potentially tip the scales, triggering a final 25 basis points rate hike by the ECB in September. As a result, there are indications of upside risks for the euro in the short term. If inflation remains resilient, there's a possibility of the euro returning to and stabilizing above 1.0950, and even retesting 1.10. Of course, much will also depend on whether the US payroll numbers surpass expectations.

GBP: Light calendar this week.The British pound has commenced the week with a moderate upswing, partially attributed to the hawkish remarks made by Bank of England Deputy Governor Ben Broadbent during the Jackson Hole event. Broadbent emphasized that the pace of inflation's deceleration is expected to be slower than its initial surge, warranting the need for sustained restrictive monetary policy. Additionally, the pound's momentum is being bolstered by a tentative shift towards risk-taking sentiment and a weakened US dollar, as London markets reopen following the UK's national holiday. Given the relatively sparse UK economic calendar for the week, the pound's trajectory will likely continue to be influenced predominantly by external factors. Notably, an important event to monitor is a speech scheduled for Thursday by BoE Chief Economist Huw Pill.

The GBP/USD currency pair (also known as Cable) might find support if my assumption holds true that markets could retract some of their bullish dollar positions prior to receiving official confirmation from US payroll data. On the front of EUR/GBP, the focus will be squarely on the euro's performance and the eurozone's upcoming inflation figures. Aligning with my optimistic stance on the euro, I anticipate a possible breach of the 0.8600 level for the EUR/GBP exchange rate.

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