Inflation expectations and EUR/USD – Commerzbank

The Fed's Federal Open Market Committee (FOMC) has presented. And now it's the hot rumor on the market: big interest rate cuts (50 basis points instead of 25). It's being discussed for today's SNB decision, it's considered possible for the Riksbank in the future, it's an issue for the Bank of England and for Banxico as well, Commerzbank’s Head of FX and Commodity Research Ulrich Leuchtmann notes.

Market to be massively surprised by inflation above expectations

“The market expects Eurozone inflation of just 1.7% over the next twelve months – well below the ECB target. See figure 1 above. While market expectations probably include a risk premium, this cannot ‘explain away’ the low Eurozone inflation expectations. In particular, the fact that inflation expectations for the subsequent twelve months (1Yx1Y) are similarly low (1.77%) shows that at these prices, the market is not just concerned with insuring itself against euro area inflation by betting on low inflation in the short term. The bets on low inflation are meant seriously.”

“If US inflation is expected to remain at or around today's levels in the medium term (CPI in August 2.5%), but considerably lower in the eurozone, equally large Fed and ECB steps should be assessed differently: the ECB's steps reduce the EUR real interest rate less than the Fed's steps reduce the USD real interest rate.”

“Please note that our economists do not at all share the market's view on inflation. They expect eurozone inflation to slowly approach the 2% target, but not to undershoot it, and even to remain slightly above the target. Our medium-term EUR/USD forecast is therefore based primarily on our expectation that the market will be massively surprised by inflation above expectations.”