Europe Expect Softer Inflation Pressures

The recent ECB consumer expectations survey has revealed a decrease in inflation outlooks. Projections for inflation three years ahead have softened from 2.5% to 2.3%, and those for the upcoming year have eased from 3.9% to 3.4% as of June. This shift is seen as a positive sign that the ECB's efforts to raise interest rates are having an impact. However, two notable points must be considered: 

a) Long-term inflation expectations continue to exceed the targeted 2.0% rate. 

b) Metrics reflecting long-term inflation expectations derived from market trends have experienced a recent significant increase.

Regarding the latter point, it's worth noting that ECB officials may have expressed concern over the 5Y5Y EUR inflation swap forward rate, which reached its highest level in 13 years on Monday at 2.67%. Although it has since slightly decreased by about 5 basis points, it remains notably elevated in comparison to the mid-July level of 2.50%. This could potentially raise questions about the conclusion of the tightening cycle.

The eurozone's schedule for this week is relatively light, but the euro faced some downward pressure after the unexpected announcement by the Italian government of a windfall tax on bank profits. This moves negatively impacted sentiment in the European equity market. The initial blow to bank stocks can partly be attributed to uncertainty surrounding the specifics of the tax. However, it has now been confirmed that the levy will not surpass 0.1% of each bank's assets. This confirmation has been received as positive news by Italian bank stocks and has contributed to a modest recovery in the euro's value.

The Italian government's decision to implement this tax follows unanswered requests from commercial banks to raise deposit rates. Spain made a similar move last year, and similar discussions have taken place in other major European economies. This situation is worth monitoring, as it could potentially ignite debates about windfall taxes on bank profits in other countries. Additionally, the possibility of banks pre-emptively increasing deposit rates to anticipate new taxation adds complexity to the equation. These developments hold significant implications from both a monetary policy transmission standpoint and for the euro's performance. In the short term, the relevance of relative equity performance in relation to EUR/USD will likely maintain sensitivity to these matters.

As global risk conditions improve and there is a perception of some relief for bank stocks, a return to the 1.10 level for EUR/USD could be feasible today.

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