EURUSD: Pressure to the Downside

EUR pressured as cyclical outlook deteriorates.

EUR: Flow of data suggests energy-bounce support fading.

The EUR/USD currency pair continues to face downward pressure as recent economic data releases, such as the factory orders data from Germany, came in weaker than anticipated. Yesterday’s industrial production data also fell short of expectations, although it did show a modest month-on-month gain of 0.3%. However, this increase was lower than the projected 0.6% following a significant decline of 2.1% in the previous period. In addition, Tuesday’s Spanish industrial production data was substantially weaker than expected. The non-seasonally adjusted year-on-year rate experienced a 4.0% decline in April, marking the poorest reading since January 2021 when the COVID-19 pandemic was still adversely impacting economic activity.

The Manufacturing PMI index, which currently stands at 44.8, provides no indication of an imminent turnaround in the prevailing weakness within industrial production. The resurgence of pessimism in this sector seems to suggest that the earlier boost in confidence triggered by the decline in energy prices is now fading. Moreover, the April retail sales data for the Eurozone, which was released yesterday, revealed stagnant month-on-month growth, falling short of expectations.

Considering the consensus for real GDP growth is barely positive, any further weak data could easily signal a contraction in GDP.

CYCLICAL UNDERPERFORMANCE IN EURO-ZONE SUPPORTING USD

Source: Bloomberg & MUFG Research calculations

The positive aspect is that the influx of data will further reinforce the expectation of a continued decrease in inflation. Recent ECB data has shown a notable decline in consumer inflation expectations for the next 12 months, dropping from 5.0% in March to 4.1% in April. Similarly, three-year inflation expectations decreased from 2.9% to 2.5%. Consequently, 2-year yields in core Europe experienced a further decline following the release of this data, just ahead of the ECB's upcoming meeting scheduled for next Thursday.

Despite these developments, I don’t believe that the recent data is sufficient to alter the ECB's perspective. While a 25 basis points hike next week is already widely expected, the flow of data does raise the possibility of market discussions regarding a potential rate increase in July. The market has largely priced in the 25 basis points hike for next week, but the Overnight Index Swap (OIS) market indicates around 42 basis points of tightening over the next two meetings, slightly lower than the end of May. However, I believe that a more significant shift in activity data would be necessary to change the ECB's stance on implementing two additional rate increases. During her speech yesterday in the European parliament, President Lagarde emphasized that "price pressures remain strong" and reiterated the guidance that policy rates would be adjusted to achieve price stability. While some hawks argue for more than two hikes (Nagel), it is most likely that two more hikes will be delivered before the summer break.

The weaker industrial production data and declining inflation in the Eurozone do shift the short-term risk balance more towards the downside for EUR/USD. However, it is probable that we will witness consolidation at these levels leading up to the release of the Consumer Price Index (CPI) data on Tuesday, followed by the Federal Open Market Committee (FOMC) meeting on Wednesday and the ECB meeting on Thursday.

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