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EUR/USD 1.1000, U.K. Inflation, and JPY as the Favored Funding Currency

EUR/USD 1.1000, U.K. Inflation, and JPY as the Favored Funding Currency

Talking Points:

- While this week is relatively quiet on the data front, there are numerous price action items of interest.

- While the recent round of major Central Bank announcements saw both the ECB and the BoE take a dovish stance to markets, an element of strength remains in both currencies. Meanwhile, the Japanese Yen continues to slide-lower, indicating its attractiveness as a continued ‘funding currency’.

- If you’re looking for trading ideas, check out our Trading Guides. And if you’re looking for ideas that are more short-term in nature, please check out our IG Client Sentiment Indicator.

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EUR/USD Jumps Past 1.1000

One of the few high-impact data releases for the week took place this morning, as Euro-Zone Q1 GDP printed in-line with expectations at .5% quarter-over-quarter and 1.7% year-over-year. But judging by price action, quite a bit more than just an in-line print is going on here as the Euro is rampantly running higher against most major currencies.

Chart prepared by James Stanley

On Friday of last week we looked at EUR/USD support around 1.0850. As of this morning, EUR/USD is more than 200 pips higher with very little pullback in the move.

Chart prepared by James Stanley

While it would be simple to ascribe this move as being directly related to Europe’s continued improvement on the economic data front, there is likely a bit more going on here. Namely, this further improvement in Euro data indicates that more stimulus is probably not in the pipeline for the European Central Bank after the current program expires in December of this year. So, as we get better and better data prints, investors are motivated to close-up short-Euro positions; and this in-turn brings on buying demand from short-cover. Given the subdued down-side reaction to the prior couple of weeks’ efforts from the ECB, and this would make logical sense: As European data improves, markets are growing increasingly optimistic that the ECB will not need to embark on another round of QE, so as the ECB tries to talk down the currency, the reaction is somewhat mitigated as market participants try to look beyond those assurances to see ‘what’s around the next corner’.

U.K. Inflation Hits 3-Year High

We’ve been discussing the prospect of higher-than-wanted levels of inflation in the U.K. since shortly after last year’s Brexit referendum: When a major currency drops 20 or 30% in a short period of time, as the British Pound did around Brexit, prices will likely begin to go up on imported products as producers try to avoid or offset diminishing margins. Mark Carney even warned us about this well-ahead of the Brexit referendum, saying that decision to leave the EU would entail slower growth, higher rates of unemployment, higher rates of inflation and a ‘sharp repricing’ in the value of the British Pound. This puts the Central Bank in an unenviable position: Do they cut rates to try to create stronger growth and lower levels of employment, even if at the behest of inflation; or do they hike rates to try to stem inflation while letting employment and growth languish?

The Bank of England has been rather clear in their direction, as just days after the Brexit referendum, BoE Governor Mark Carney held an impromptu press conference in which he talked up the prospect of monetary accommodation to proactively offset Brexit risks. In August, the BoE delivered a ‘bazooka’ of stimulus, and by November, the Bank of England already had to guide inflation expectations-higher.

Since then, each inflation print in the U.K. has been a potential pain-point. At last week’s Super Thursday at the Bank of England, the BoE said that they’d tolerate an ‘inflation overshoot,’ or levels of inflation beyond their target without having to adjust rates-higher. The BoE said that inflation could increase to as much as 3% by the end of the year, and this would put U.K. consumers and savers in a rather rough position as inflation far outstrips bank rates or wage gains.

This morning’s inflation print out of the U.K. for April came-in at its highest level since September of 2013, printing at 2.7% as prices continue to move-higher in the U.K. Last week’s BoE meeting is likely serving as somewhat of a depressant for this morning’s print, as Sterling lags Euro thus far on the morning; but the key variable to keep in mind is how the BoE has continually been behind on inflation expectations and the fact that a more-widespread global recovery could serve to boost actual inflation numbers even more, beyond those expectations of the BoE.

Chart prepared by James Stanley

Dollar Down the Drain – But Watch the Japanese Yen

DXY has been putting in some troubling formations of recent, including yet another support break this morning as the Greenback runs down to a fresh post-Election lows.

Chart prepared by James Stanley

The major down-side of DXY is overexposure to the Euro, as our own Christopher Vecchio has pointed out on numerous occasions. DXY was created before the Euro came into existence, and to account for the single currency, DXY simply commingled prior allocations of Deutchmarks and Lira and other assorted European currency to arrive at a DXY instrument that was more than 50% allocated to Euro currencies.

So when we see the Euro staging a major breakout, as it is today, DXY is going to look very bearish to account for that new Euro-strength. But if we look at a pair like USD/JPY, we’ll actually see a bit of recent strength in the Greenback – and this alludes to the idea that the Japanese Yen may be a bit more attractive for weakness in the immediate future. So for those looking to buy EUR/USD, EUR/JPY may be a more amenable option for long-term plays, and for those looking to buy GBP/USD, GBP/JPY may be a more attractive venue for such an approach.

On the chart below, we’re looking at the recent bullish backdrop in USD/JPY to highlight just how much weaker the Japanese Yen has been versus the U.S. Dollar, and this is representative of the fact that the Yen will likely remain favored as a ‘funding currency’, as the Bank of Japan appears to be nowhere near tighter policy options.

Chart prepared by James Stanley

--- Written by James Stanley, Strategist for DailyFX.com

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DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.

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