- EUR/USD sags, as European currencies lag & USD advances.

- Even after EZ inflation surges to 0.9%, core CPI rises to 1.4%.

- As one-off items, base effects mislead over EZ inflation picture.

- ECB fears drive EUR adjustment, EUR/USD supported at 1.20.

Image © European Central Bank, reproduced under CC licensing

EUR/USD spot rate at time of writing: 1.2020Bank transfer rate (indicative guide): 1.1599-1.1683FX specialist providers (indicative guide): 1.1840-1.1936More information on FX specialist rates hereThe Euro-to-Dollar rate was on course for a hat-trick of declines Wednesday as European denominations lagged other risk currencies as well as a resurgent Dollar, and even after January's blowout inflation reading, although the nearby 1.20 level offers formidable support to Europe's single currency.

Eurozone inflation rose to 0.9% last month, Eurostat data showed on Wednesday, from -0.3% previously and when consensus had been looking for an already-large increase to 0.6%. Core inflation, the more important measure for rate setters at the European Central Bank (ECB), rose from 0.2% to 1.4% when consensus looked for only 0.9%.

"These are startling data, but we suspect the true consensus was prepared, more-or-less, in light of the very strong advance data," says Claus Vistesen, chief Eurozone economist at Pantheon Macroeconomics. "We should be taking these numbers with a healthy helping of salt."

Europe's inflation rates have long been too low for the European Central Bank, which is charged with using its monetary policies in order to deliver inflation that averages a steady "close to, but below 2%" over the mediumt-term.

As a result and on the face of it Wednesday's data would appear to suggest that Eurozone policymakers are well on their way back to dry land with their inflation target, although economists including Pantheon's Vistesen have argued that strength in the latest data is misleading.

Above: EUR/USD (blue line) with EUR/CNH (orange) and Pound-Euro rate (red & green) at 4-hour intervals.

"We are sympathetic to the idea of a sharp increase in core inflation, eventually, as pent-up demand hits a constrained supply side. But this is not what the January numbers reflect. We are even inclined to accept the idea of stagflation-lite, driven by a sharp increase in energy inflation and supply-side pressures driving up core prices, though we shouldn’t be using today’s data to claim that this is now happening. More evidence is needed," Vistesen says.

Europe's single currency wasn't fooled by the figures, as it was seen lower against the Dollar, Pound and other currencies in the aftermath. The Euro-Dollar rate slipped -0.11% in Wednesday trading to be quoted near to the 1.20 handle, which is a psychologically important level, the integrity of which could be key to the outlook. Meanwhile, the Dollar continued its resurgence even as stocks and commodities rose, while Pound Sterling took a breather from its rally.

"There have been some signs that the correlation trade (equities higher/USD lower) is experiencing fatigue. EUR/USD has not rallied in tandem with risk over the last three sessions suggesting that the common currency may no longer be a good proxy for macro sentiment," says Sarah Ying, a strategist at CIBC Capital Markets. "While the retail frenzy in equities is idiosyncratic to only a few names, it did impact broader indices as well, which we would expect to impact FX if the correlation trade was still alive."

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The 1.20 level offers formidable support to the Euro although some traders have warned of a "huge wave of capitulation" in the event that it sustains a daily close below there. Meanwhile, technical analysts note that 1.2014 is the precise landmark level on the charts, below which Europe's single currency would be susceptible to a slide back toward 1.1750 and possibly even lower, with any fall below 1.1695 enough to put the breakout from a 12-year downtrend in danger.

"Assuming that the market recovers between here and the 1.1945 23.6% retracement of the move up since March 2020 then the medium-term bull trend remains intact. Our targets remain the 1.2556 2018 high and 1.2623, the 200 month moving average," says Karen Jones, head of technical analysis for currencies, commodities and bonds at Commerzbank. "Loss of 1.1945 will imply a deeper sell off to 1.1750 and possibly the 1.1695/02 support, this is the 38.2% retracement and the September and November lows. It would also represent a return to point of break out from the previous 12 year downtrend."

Above: Euro-to-Dollar rate shown at daily intervals with GBP/USD (orange) and S&P 500 Index futures (blue).

Europe's single currency has slipped through the performance rankings in 2021 and there's a risk it might continue to do so over the coming weeks following a 2020 rally that lifted EUR/USD roughly 10% in the year to late January. That increase is a big part of why the Euro is now an FX underperformer.

"Unemployment and insolvencies will likely first rise before they fall, keeping a lid on wage and price growth. A strengthening euro could also contain price gains throughout the next two years. By the end of 2022, inflation will likely be still well short of the ECB’s “below, but close to, 2%” target," says Florian Hense, an economist at Berenberg. "The one-off driven snapback in inflation in 2021 should not be mistaken for a rapid rise in underlying price pressures. Underlying inflation will increase only gradually over the medium-term. In 2022, inflation will – if anything – rise much more slowly and possibly even fall at the start of the year as positive base effects fade. More fundamentally, capacity utilisation will take time to return to pre-pandemic levels despite strong demand growth."

ECB policymakers have just emerged from what is a lost decade for Europe as far as the bank's inflation target is concerned. The exact cause of Europe's lacklustre inflation pressures is a matter of fierce debate in academic, professional and policymaking circles although what matters most for the Euro in the short-term is that without a further downward adjustment in either or both of EUR/GBP and EUR/CNH, a EUR/USD recovery would simply eat into whatever is left of the already-insufficient inflation pressures.

This is because irrespective of whichever precise measure or other version of such a barometer is used, trade-weighted Eurozone exchange rates are substantially composed of the Dollar, Chinese Yuan and Pound Sterling, which means that marked increases in those exchange rates can impact the prices of import and export goods. When these Euro exchange rates rise, imported goods become cheaper and the downward pressure on European inflation grows heavier, much to the chagrin of the ECB.

"Last year the EUR recovery was partly driven by rising EU exports to China - so it doesn’t help that China looks to be entering a period of slower economic activity," says Jordan Rochester, a strategist at Nomura. "European inflation spiking higher and ECB communications on the strength of the currency add uncertainty for front-end rates and also the longevity of PEPP beyond this year, both of which would be growth and EUR negative."

Above: EUR/USD (blue line) with EUR/CNH (orange) and Pound-Euro rate (red & green) at monthly intervals.