Flash inflation readings from the Eurozone next week could cause more misery for the euro, which is already under pressure from a transforming political landscape across the bloc and an empowered Matteo Salvini in Italy. Eurostat will publish the flash report on Tuesday at 09:00 GMT but the readings will probably not be good news for the European Central Bank as headline inflation is expected to decline.
Eurozone inflation likely eased in May
After rising by 1.7% year-on-year in April, the headline rate of inflation as measured by the Harmonised Indices of Consumer Prices (HICP) is forecast to fall back to 1.3% in May. The two underlying measures of inflation also headed higher in April, though they remained within their recent ranges. The core rate excluding food, energy, alcohol and tobacco prices, which the markets put more emphasis on, is forecast to ease from 1.3% to 0.9% y/y.
The HICP rate is the ECB’s officially targeted measure of inflation, but ideally, the Bank also wants to see core prices to show a sustained move towards its goal of “below, but close to 2%” before it claims success. But with the Eurozone economy still lacking sufficient growth momentum amid all the regional and global uncertainties, achieving this is taking much longer than policymakers had anticipated.
Inflation expectations have been falling to worrying levels
A new worry for the Bank is a slide in inflation expectations. Five-year market-based expectations of inflation have fallen sharply since late 2018 and this week hit the lowest since September 2016, reaching 1.2987%. Governing Council members expressed concern about this development in the account of their April policy meeting, though for now, they seem to think the decline is a temporary response to the worsening economic outlook, suggesting they don’t see any urgency just yet for further policy action.
However, should the outlook continue to deteriorate, it may only be a matter of time before the ECB has to consider ways to loosen monetary policy again. The political situation in the European Union certainty isn’t doing much to shore up business confidence at the moment. Although the European elections weren’t quite as disastrous for the mainstream parties as had been anticipated, they did produce a very fragmented Parliament, suggesting it will be harder for all the different factions to reach consensus, creating uncertainty about the EU’s future policy agenda.
Italy a big risk for the euro
But a potentially bigger headache for policymakers is Italy. The League party, which forms one half of the governing coalition, was the big election winner in Italy, and its leader, Salvini, will likely use this to push harder against conforming to the EU’s fiscal rules. A fresh crisis in Italy, along with the ongoing Brexit and trade uncertainty, not to mention the possibility of the trade war reaching Europe, pose great downside risks for the euro in the short to medium term.
A breach of the $1.11 handle is looking increasingly likely for the single currency given the shortage of positive headlines. Weaker inflation numbers on Tuesday could be one catalyst that could push euro/dollar below 1.11, especially if the nearest support at 1.1109 – the 123.6% Fibonacci extension of the 1.1174-1.1448 upleg – is broken. If there is a drop below this level, the focus for sellers would turn to the 138.2% and 161.8% Fibonacci extensions at 1.1069 and 1.1005, respectively.
