Dollar continues to rally as Eurozone falls into deflation

Enrique Díaz-Álvarez12/Jan/2015Currency Updates

Financial volatility continued into the second week of the year, and the trend to a stronger Dollar showed no signs of abating. The negative inflation print we had expected in the first quarter of 2015 actually arrived even earlier, as December inflation in the Eurozone dropped to -0.2% YoY, making it all but certain that the ECB will announce further easing measures at its January 22nd meeting. Unsurprisingly, the common currency struggled all week, and lost another 1% against the Dollar. More puzzling was Sterling underperformance against both the Dollar and the Euro, in a week where UK news was balanced and fairly neutral.


Last week we saw mixed economic news in the UK. Construction and industrial production in November both disappointed expectations, while the Markit jobs report continued to indicate strong growth in both hiring and pay increases. The construction and industrial production data, as well as a drop in the services PMI business confidence to 55.8, are consistent with a slowdown in UK growth towards the 2-2.5% level. This is down from the 3% growth the UK had posted over the past few quarters, but still very respectable. We maintain our call for a first Bank of England interest rate hike in the third quarter of 2015, but this call is contingent on the absence of any further significant negative inflation surprises. However, currency markets are clearly taking a different view, as Sterling fell against the US Dollar and, more surprisingly, the Euro.


Deflation came even earlier to the Eurozone than we had expected. Dramatic falls in energy prices drove December headline annual inflation to -0.2%, down a whopping 0.5% from the November level. Stripping the more volatile food and energy prices leaves core inflation at a less alarming +0.8%. However, both the ECB and European economic agents have traditionally focused on the headline number. The Eurozone is now the only major economic area where prices are falling on an annualised basis and, in the absence of a serious rebound in the price of oil, this condition is expected to last throughout 2015. The ECB will be deeply conscious of its failure to achieve its own inflation targets; the announcement of further monetary easing measures, including purchases of sovereign bonds, is a virtual certainty at the January 22nd meeting. However, markets were apparently expecting the negative inflation print as, although the Euro fell against the US Dollar, it actually managed to eke out a small gain against most other G10 currencies over the week.


The December payrolls report confirmed that the US economy continues to create jobs at a very healthy pace of roughly 250,000 per month. However, the positive job creation numbers contrasted with a reported monthly decline of 0.2% in worker pay. Currency markets chose to focus on the latter and the Dollar gave up roughly half of its weekly gains in the hours between the report release and Friday market close.

The dip in pay is certain to draw the attention of the Federal Reserve. Such weakness in pay in a month of strong job creation is very unusual. However, one month does not a trend make. There is a very good chance this weakness will be reversed in the coming months and turn out to be a statistical fluke. If it doesn’t, and real wages stop increasing, this will materially impact the Federal Reserve hiking schedule for 2015.


Written by Enrique Díaz-Álvarez

Chief Risk Officer at Ebury. Committed to mitigating FX risk through tailored strategies, detailed market insight, and FXFC forecasting for Bloomberg.