Warning: Do Not Tighten Policy Too Quickly

August 14, 2017

| Fullerton Markets

Warning: Do Not Tighten Policy Too Quickly

What if markets are over-confident on ECB to tighten, sell EUR/USD?

Global inflation set for decelerating in second half of the year, which would induce more central banks to prefer a lower FX rate

US CPI growth in July increased 0.1% m/m, making a 1.7% y/y growth, both figures are slightly lower than expected. Inflation has been decelerating for five consecutive months, raising questions whether Fed's annual target of 2% can be achieved. The dollar fell sharply after the disappointing data.

Still, we don’t think the tepid inflation rate will change the path of Fed policy normalisation this year. Given the current high valuation in US stocks market and falling US dollar, there is room for Fed to raise the policy rate one more time this year. Comparing the current Fed fund rate at 1.25%, Taylor rule model suggests the current US interest rate should have been 200-250bp higher. Besides that, steady US labour market supports a higher interest rate as well.

Although the slowing US inflation seems to have little influence on Fed's interest rate decision in second half of the year, but it complicates the capital market in this period. Not only investors are concerned about US inflation and yield levels, but central banks around the world are also paying extreme attention to that. Once stagnation of the inflation in United States or China is seen, other regions including the euro area, emerging markets and Oceania will be affected as well. For now, most of the developed economies’ inflation growth has been below their central banks’ target (most of them set at 2%). Having said that, none of these central banks are willing to see their own FX rates staying in appreciation trend. Most of the central banks nowadays have nearly no room to cut policy rate, lower exchange rate is the only way to prevent monetary policy from tightening too quickly.

Take ECB and euro for an example. The appreciation of euro over the past few months is not only against the dollar, but a broad gain across a basket of currencies. Data last week showed Germany's export decline in June was almost at the fastest pace in the past two years. This data may be enough to draw the attention of ECB’s Draghi to whether it is necessary for him to “talk down” euro. In European equities market, appreciation of euro prompts investors to sell their portfolio in medical, consumer, and energy sectors. While in United States, many companies reported better than expected earning results due to weak dollar. If this phenomenon continues in the next few months, we believe ECB’s monetary policy stance will shift from the current "neutral" to "slightly dovish". This is not difficult for Mario Draghi, he can easily postpone the policy-tightening schedule by expressing his concern on slower inflation, but the real intention behind is to pressure euro and bond yields lower.

Our Picks

EUR/USD – Slightly bearish. Dollar may have some technical rebound amid the release of FOMC Minutes this week. This pair may retrace to 1.1780.