Inflation Remains the Market’s Priority

Events in Russia have had little discernible impact on the FX market so far. Instead, the hot topic of high inflation and what policymakers are prepared to do about it remains the market's priority. This will be at the top of the agenda at this week's ECB's annual symposium in Sintra. Expect another mixed week in FX markets and possible BoJ intervention.

USD: Geopolitics has yet to make its mark

The recent events in Russia over the weekend have had minimal impact on global financial markets thus far. There hasn't been a significant rush towards safe-haven assets like the short-term US Treasury market, with only a 2 basis points decrease in two-year yields since Friday. Crude oil prices failed to hold onto slight gains in Asia, and the Asian equity market remained relatively quiet.

In the foreign exchange market, there is no clear indication of investors seeking safety in the US dollar or a notable outperformance of defensive currencies like the Japanese yen and Swiss franc. This subdued response can likely be attributed to two factors: firstly, the lack of clarity regarding what lies ahead after the challenge to President Putin's authority, and secondly, the financial markets having already endured a year of a stronger dollar and higher energy prices following the Russian invasion of Ukraine.

Rather, the market's attention is primarily focused on inflation. Central bankers and governments are facing criticism for maintaining loose monetary and fiscal policies for an extended period. This topic, especially monetary policy, will be the main point of discussion at the annual ECB symposium in Sintra this week. Several central bank governors from the G7 nations are expected to attend and are likely to deliver a hawkish message similar to the one conveyed by Federal Reserve Chair Jerome Powell during his recent testimony to Congress.

Consequently, yield curves are expected to remain strongly inverted as investors evaluate the potential for an impending recession, and the US dollar is anticipated to remain robust against currencies lacking monetary defense. For instance, the USD/JPY currency pair is likely to maintain its bullish momentum. In addition to Powell's remarks in Sintra on Wednesday, a significant event in the United States this week will be the release of core PCE inflation data for May, scheduled for Friday. If the data shows another high reading, particularly around 0.4% month-on-month, it implies that the Federal Reserve will continue with its hawkish stance without any signs of easing.

The US Dollar Index (DXY) is expected to fluctuate within a range of 102.00 to 103.00 this week, while the USD/JPY pair is likely to approach the 145 intervention zone.

EUR: German IFO can keep the Euro subdued

On Friday, Europe witnessed a disappointing set of Purchasing Managers' Index (PMI) data, with the services sector showing concerning signs of decline, aligning with the already somber state of the manufacturing sector. The release of this data resulted in a decrease of approximately 50 pips in the EUR/USD currency pair.

Superficially, the narrative of central banks needing to maintain higher interest rates for an extended period does not bode well for the pro-cyclical Euro. However, the hawkish stance of the European Central Bank (ECB) has provided some defense against the elevated interest rates in the United States and has pushed EUR/USD back above 1.09. This stance also strengthens the expectation of at least two additional 25 basis points rate hikes (in July and September) and may counteract the modest easing anticipated in 2024.

This current environment suggests that EUR/USD will likely continue to trade within the range of 1.0850 to 1.1000, and the favorable scenario of a soft landing and a more accommodative Federal Reserve policy seems to be further postponed.

In other developments this week, it is important to monitor the Riksbank rate meeting on Thursday. Unless the meeting results in a hawkish rate hike, EUR/SEK is expected to rise back above 11.80.

GBP: No push back against 6%+ Bank Rate this week

The financial press is currently engaged in extensive discussions regarding central bankers' transition from the relatively straightforward decline in headline inflation driven by base effects to the more challenging task of reducing core inflation, which stands at around 5% for most countries and even higher at 7% for the Bank of England. Given this situation, it is expected that there will be no resistance from Bank of England officials in terms of the Bank Rate being priced above 6% early next year. Simultaneously, it is anticipated that the government will not concede any ground on mortgage interest relief, as doing so would only make the Bank of England's job more difficult.

The dip in Eurozone PMI data last Friday led to a decline in EUR/GBP. Despite concerns about a potential hard landing for the UK economy, I maintain my initial stance as outlined in my recent analysis on the Bank of England's response. Specifically, I believe that a highly inverted yield curve is likely to outweigh fears of a hard landing, and the British pound will retain its recent gains for the time being.

In terms of the UK calendar for this week, the focus will primarily be on Bank of England speakers, with Wednesday's event featuring BoE Governor Andrew Bailey being the main highlight. It is anticipated that EUR/GBP may retreat to 0.8520 this week, while GBP/USD should find support below 1.27.

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