Twin Inflation Tales Signal Diverging Path for Dollar, Euro

(Bloomberg) -- Market-derived inflation expectations are climbing on both sides of the Atlantic -- but the strong euro and the weak dollar underscore diverging economic paths that suggest the greenback’s losing streak may gather more pace.

The shared currency climbed to a three-year high against its U.S. counterpart Wednesday, spurred by strong manufacturing data across the region. That’s affirming hopes of a benign uptick in price pressures consistent with consumer demand and wage increases. The greenback, for its part, fell to a three-year low against its major peers after Treasury Secretary Steven Mnuchin endorsed its decline as a fillip for U.S. trade.

The contrasting currency fortunes despite a shared inflation trajectory are the latest indication that the monetary path is bearish for the dollar, according to strategists.

"It shows the market’s not rethinking the terminal Federal Funds rate despite inflation, whereas any sign of inflation is perceived as a European Central Bank game-changer," says Societe Generale SA strategist Kit Juckes. "U.S. inflation expectations rising faster than in Europe also help real yield differentials a bit in the euro’s favor."

The greenback just isn’t getting a break: five-year real borrowing costs are at two-year highs, while U.S. economic data are strong and markets are factoring in tax stimulus. Yet the currency has weakened against every Group-of-10 peer since President Donald Trump’s inauguration. The Bloomberg Dollar Index tumbled to a fresh three-year low Thursday before paring losses.

"Late-cycle inflation does little for the dollar since it’s priced in most of the Federal Reserve cycle," according to Mark McCormick at Toronto-Dominion Bank. "Meanwhile, the euro recoupling with inflation expectations is a sign that market is responding to eventual policy normalization."

Currency traders may also be wagering on a floor on U.S. inflation-adjusted bond yields, he adds. "There’s a question about whether the Trump-led Fed would respond to inflation: will there be a preference to generate inflation but not tighten aggressively, leading to lower real rates?"

In other words, an uptick in expected price pressures -- while market-implied real rates remain subdued -- point to a weaker dollar. In the euro area, meanwhile, it’s signaling a brighter outlook for growth and interest rates.

"Along with risk-on dollar weakness, rising inflation expectations in the U.S. may be leading to some currency depreciation," Sanford C Bernstein & Co strategists led by Noah Weisberger wrote in a note.

To contact the reporters on this story: Sid Verma in London at sverma100@bloomberg.net, Kristine Aquino in London at kaquino1@bloomberg.net.

To contact the editors responsible for this story: Samuel Potter at spotter33@bloomberg.net, Joanna Ossinger, Dave Liedtka

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