• EURUSD looks overvalued against different rate spreads
  • Subdued oil prices could make the ECB’s price target harder to achieve
  • ECB’s patience to the euro rally could be coming to an end

The euro has been enjoying excellent performance for recent weeks as the common currency has strengthened against the greenback substantially from under 1.06 seen in April to above 1.18 nowadays. At the same time, oil prices (WTI) have tumbled from above $53 to under $43 albeit they have managed to catch up with some of losses. Either way, given a longer-term prospect they remain little changed walking a tightrope between $55 and $42/44 and for that reason they do not longer carry a welcome factor to higher inflation.

Nordea’s analysts weigh in and claim that with EUR/USD at 1.18 it is 8% higher than ECB assumed in June, and the trade-weighted EUR is some 5% stronger than expected. This will weigh on HICP inflation to the order of -0.5 percentage points (according to ECB’s scenario analyses). With 2019 HICP inflation seen at a modest 1.6% in June, this implies a lower-for-longer environment for inflation.

link do file download linkThe EURUSD looks overvalued given various rate spreads, notwithstanding a longer or a shorter end of the curve. Source: Nordea Bank

Moreover, the bank notices that if EUR/USD were to rise to e.g. 1.25 the FX-effect would cut 2019 inflation by roughly 1 percentage point, dragging 2019 inflation down to 0.6%. EUR/USD at 1.25 would thus prompt an enormous disinflation shock, but only unless oil prices keep climbing.

link do file download link2019 inflation effect from the EURUSD and Brent prices. Source: Nordea Bank

Having assumed the EURUSD at 1.25 and Brent prices at $60, the effect on 2019 inflation will be -0.4%. If oil prices instead were to climb to $70, the energy-price effect would outweigh the disinflationary effects from the stronger currency. But if oil prices instead fall back to $40, then there would basically be no inflation at all (0.1%) in 2019.

At the end of the day, ECB’s patience to the stronger euro could be coming to an end as the firmer currency could hold off on striking the inflation goal. That said, there is a likelihood that if the euro pops above 1.20, it could prompt the ECB to step in with dovish remarks. Will verbal interventions change anything? They could slow down the euro’s rally but it’s unlikely to reverse a long-term trend on the pair.

The next ECB’s interest rate decision is scheduled to take place on 7h September.