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EUR/USD continues to see the euro weakening against the dollar, as the buck stomps down all before it. The start of tapering by the ECB has not helped the euro, with real interest rates still stubbornly negative. The pair is currently trading at 1.1600.

The worry for Europe’s policymakers must be that market watchers  and forex day traders alike may be beginning to see signs of a weakening in the credibility of ECB’s transitory inflation mantra.

This comes at a time when the European economic recovery remains on track. Indeed this week’s economic sentiment indicator improved further in September to 117.8 compared to the previous month’s 117.6.

But while confidence improved in industry and construction, it was a different story for services, where sentiment fell -1.7, with retail particularly badly hit, falling -3.3.

eur/usd - europe outlook


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Economic sentiment indicators rose for most of the continent’s major economies, up in Spain, Germany and the Netherlands, although was down in France and Italy.

Labour market data shows continuing improvement. Unemployment expectations fell 5.4, while employment expectations was up 0.8 and that likely explains the further improved all-important consumer confidence reading , which rose 1.3.

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Lagarde says don’t overreact to supply shocks – but is the ECB right?

Which brings us to the question inflation and whether it is transitory, as ECB president Christine Lagarde reiterated on Tuesday, or something different. “The key challenge is to ensure that we do not overreact to transitory supply shocks,” she insisted.

We will get the latest reading on price data for the Euro Area tomorrow. Inflation will very likely be higher than last month but by how much?

That all depends on energy prices and they are charging ahead. If labour expectations are. key determinant of consumer sentiment, then we should also say that inflation is probably even more so.

Inflation hurts sentiment because it reduces what consumers can spend on other things – it is a consumption dampener. Wholesale gas prices are continuing to rise at a stratospheric rate and crude oil is at three year highs.

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Europe outlook: Energy price climb will start hurting wider consumption

The European benchmark Dutch TTF hub October gas price rose €4.7 to €84 yesterday per megawatt hours (MWh).

Refinitiv analysts expect that critical Yamal pipeline, which saw throughput fall 50% on Tuesday but was up 60% on Wednesday, to come under capacity pressure as the winter season kicks in from the beginning of October. This is something that happens every year but could be a lot worse this year as worldwide competition for gas supplies tightens.

In China power outages are spreading because of a mixture of emission restrictions and coal supply shortages due to restrictions on imports from Australia, feeding through to more upward pressure on the natural gas prices.

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Predictions of a colder than usual winter in Europe won’t help either.

Not surprisingly, therefore, consumer inflation expectations rose for the ninth straight month and selling price expectations in manufacturing are at the highest level since records began.

Outside of the energy complex, prices are rising across the board as supply disruptions and crucial shortages drive prices higher.

All the data suggests the economic recovery remains on track, as we have seen, but the energy prices may be just the most obvious expression of the elevated nature of the general rise in prices.

Euro Area 3.3% inflation forecast may be conservative

Euro Area inflation is forecast at 3.3% year on year for September, up from 3% previously. Core inflation (excluding energy and food) is forecast to be 1.9% as against 1.6% in August.

But it is a fiction to exclude food and energy. Food prices are up around 30% this year according to the UN World Food Price Index.

In case you have forgotten, the ECB targets 2% for inflation, so even by its own standards inflation is running hot.

The closely watched five-year forward inflation swaps rates, which is seen by central banks as a good guide to the future direction of inflation, has ben steadily increasing. On 17 March 2020 it was 0.8; on 28 September 2021 it was 1.8, according to date from Bloomberg, which is indicative of faster rate of price increases.

German bunds still negative but creeping higher

The bond market has taken note. For example German bunds are creeping higher, from -0.44 on 30 August to -0.18 on 28 September.

Meanwhile the US 10-year Treasury note yield has ended its long swoon since March and has turned sharply higher, sending equities (at least temporarily for now) into a minor tantrum. Yields are at 1.528 after jumping to 1.55 earlier in the week, to currently trade at the highest level since July. 10-year yields peaked this year at 1.74%.

How long the spread between European and US yields can continue to widen without it leading to negative distorting impacts is anyone’s guess.

And the Bank of England will be increasing interest rates sooner than markets had previously thought likely – today’s revision higher in GDP will strengthen the hand of the hawks at Threadneedle Street.

More evidence of accelerating inflation in Europe is certain to raise alarm among the ECB’s hawks and that should bolster the euro.

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