Euro Doves Face Reality
Europe has been our recent focus, and not just because the US has been off for Thanksgiving and shopping. We emphasised our contrarian call that Euro pessimism was overdone, with economic data and policy guidance since then supporting our view.
The Euro’s trend weakness reflects rate differentials that are already stretched, with ECB cut pricing at the extremes erroneously priced for the Fed two months ago. Labour market data matter, and not just to the Fed. Unemployment trends are even more hawkish in the Euro area, and the ECB should clarify the policy relevance of this. Seasonality also supports a fading of the fundamental consensus story. EURUSD hasn’t fallen into yearend since 2016, and crowded positioning could compound the reversal (see Wrestling Euro Bears Before Christmas).
Comments from ECB’s Schnabel about gradualism and a 2-3% neutral rate promptly backed up our contrarian call. With the deposit rate already at 3.25%, her view recognises that policy may already be scarcely restrictive. It doesn’t leave space for the forceful cutting cycle that markets price. Although markets trimmed expectations for ECB easing in the short term, pricing for end-25 held firm, preserving space for a hawkish revaluation that can support EURUSD.
The previously released PMI data increasingly appear as gloomy noise after the equivalent ESI surveys broadly revealed resilient output and employment across sectors and countries. Price expectations are also at or above their long-term averages, signalling sticky inflationary pressures rather than any dovish shock to below-target levels (see EA Activity Sentiment Is Floating Fine).
Meanwhile, November's flash Euro area inflation data increased by another 0.3pp to 2.3% y-o-y. Headline surprises were small and balanced, but the resilience doesn’t fit dovish pricing. Core and services price inflation rates were little changed at above-target levels. They will likely rise again in December and stay too high throughout 2025. The ECB believes policy is tight and demand is too weak, allowing it to cut again in December. Nonetheless, gradualism is required to avoid over-easing amid ongoing data resilience (see ECB Gradualism Secured By Reflation).
Gradualism was not displayed elsewhere this week, with the RBNZ cutting by 50bp. It believes neutral rates are little changed relative to before the pandemic, which makes monetary conditions particularly tight. Most central banks don’t share that view, nor are they willing to bet so heavily on it being correct when unemployment often remains lower and more stable than in New Zealand. Meanwhile, Korea surprised expectations with a 25bp cut. References to uncertain US policies are legitimate risks for Korea. How Donald Trump tries to end the Russia/Ukraine war will also impact the Korean peninsula and the Taiwan Strait (see The US And The ‘Axis of Upheaval’).
We also see Donald Trump’s re-election breaking global momentum in green policies. The COP29 flop demonstrated the green bubble’s deflation amid a return of much-needed pragmatism. The EU and UK face competitive pressure to soften their few plans to lower emissions. For example, mandating synthetic fuel would pivot clear from China’s EV advantage. Preserving the non-green capital stock would reverse some stagflationary pressures. Adaptation remains the answer to climate change, even if many don’t want to hear it (see Green Bubble Deflating).