Euro set for third weekly decline as hawkish Federal Reserve outlook weighs

EUR/USD edges higher as the US Dollar pauses, but the pair remains on track for a third straight weekly decline.
Hawkish Federal Reserve expectations and elevated US Treasury yields continue to support the Greenback.
Traders look ahead to next week’s US PCE, NFP and Eurozone HICP inflation data for fresh policy clues.

EUR/USD edges higher on Friday as the US Dollar pauses after a strong weekly rally, allowing the Euro to recover some ground. However, the pair remains on track for a third consecutive weekly decline. At the time of writing, EUR/USD trades around 1.1400 after falling to 1.1359 on Thursday, its lowest level since July 28.

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The US Dollar’s rally this week has been driven by growing expectations that the Federal Reserve (Fed) could raise interest rates again after delivering a 25-basis-point hike last week. Recent comments from Fed officials that additional tightening may be needed to bring inflation back to 2% encouraged traders to increase October rate hike bets, pushing yields and the US Dollar higher.

The US Dollar Index (DXY), which tracks the Greenback’s value against a basket of six major currencies, trades around 101 after reaching 101.40 on Thursday, its highest level in nearly two months. Meanwhile, the benchmark 10-year US Treasury yield hovers near 5.22%, at levels last seen in 2007.

Friday’s US data offered a mixed picture. The University of Michigan (UoM) Consumer Sentiment Index rose to 48.1 in September from 47.8, beating expectations of 47.6. The Consumer Expectations Index increased to 46.3 from 45.8. However, inflation expectations were unchanged. 1-year inflation expectations held at 4.6%, while the 5-year measure remained at 3.4%.

Traders now look ahead to next week’s Personal Consumption Expenditures (PCE) inflation report, the ISM Manufacturing Purchasing Managers’ Index (PMI) and the Nonfarm Payrolls (NFP) report. The data could shape expectations for the Fed’s October meeting, with the CME FedWatch Tool showing around a 66% probability of a rate hike.

On the Eurozone side, the European Central Bank (ECB) has already raised interest rates twice this year, while markets are pricing additional tightening. However, policymakers have not committed to a predetermined policy path and continue to stress a meeting-by-meeting approach, while noting that higher Oil prices have not produced significant second-round inflation effects so far.

Next week’s preliminary Eurozone Harmonized Index of Consumer Prices (HICP) data will be closely watched, with headline inflation expected at 3.5% and core inflation at 2.6%, up from 3.2% and 2.4%, respectively.

Inflation FAQs

What is inflation?

Inflation measures the rise in the price of a representative basket of goods and services. Headline inflation is usually expressed as a percentage change on a month-on-month (MoM) and year-on-year (YoY) basis. Core inflation excludes more volatile elements such as food and fuel which can fluctuate because of geopolitical and seasonal factors. Core inflation is the figure economists focus on and is the level targeted by central banks, which are mandated to keep inflation at a manageable level, usually around 2%.

What is the Consumer Price Index (CPI)?

The Consumer Price Index (CPI) measures the change in prices of a basket of goods and services over a period of time. It is usually expressed as a percentage change on a month-on-month (MoM) and year-on-year (YoY) basis. Core CPI is the figure targeted by central banks as it excludes volatile food and fuel inputs. When Core CPI rises above 2% it usually results in higher interest rates and vice versa when it falls below 2%. Since higher interest rates are positive for a currency, higher inflation usually results in a stronger currency. The opposite is true when inflation falls.

What is the impact of inflation on foreign exchange?

Although it may seem counter-intuitive, high inflation in a country pushes up the value of its currency and vice versa for lower inflation. This is because the central bank will normally raise interest rates to combat the higher inflation, which attract more global capital inflows from investors looking for a lucrative place to park their money.

How does inflation influence the price of Gold?

Formerly, Gold was the asset investors turned to in times of high inflation because it preserved its value, and whilst investors will often still buy Gold for its safe-haven properties in times of extreme market turmoil, this is not the case most of the time. This is because when inflation is high, central banks will put up interest rates to combat it. Higher interest rates are negative for Gold because they increase the opportunity-cost of holding Gold vis-a-vis an interest-bearing asset or placing the money in a cash deposit account. On the flipside, lower inflation tends to be positive for Gold as it brings interest rates down, making the bright metal a more viable investment alternative.