Disappointment regarding inflation cools the dollar and debt markets (Daily analysis 11.03.2021)

The improvement in investment sentiment is supported by the lack of signs that the US inflation is getting out of control. The outcome of yesterday's bond auction also does not indicate weakening demand for US Treasury securities, despite recent dynamic increases in yields.

The US fiscal package is now only a signature of Joe Biden away from coming into force. As a result, market sentiment improved appreciably. Also, fears of a correction on the stock markets have weakened. The day before yesterday, the technology market recorded a several percent increase and yesterday, the Dow Jones average, an index of the thirty largest Wall Street companies, set all-time records.

In such an environment, the dollar is forced onto the defensive - the EUR/USD pair has already managed to claw back above the 1.19 mark and is close to confirming a short-term bottom. Increased risk appetite keeps Scandinavian currencies and the pound leading the way this week. The emerging markets space is rallying as well.

Dollar weakens after inflation disappointment

This year, the argument favouring the dollar is the strong economic situation, especially compared to the Eurozone. However, good economic prospects alone are usually not enough to support the US currency. On the contrary, there are often periods when strong growth in the US pushes capital to other markets, especially emerging markets. After all, the more the largest economic mechanism accelerates, the better it is for the global system of interconnected vessels. The financial markets are also optimistic in this situation. What separates growth that is good for the dollar from growth that is harmful to it? Inflation and the outlook for central bank policy.

In Anglo-Saxon culture, there is a fairy tale about three bears and a lovely golden-haired girl Goldilocks. Our little heroine tries porridge from three bowls to find out that the best porridge is the one with an intermediate temperature. Neither too hot nor too cold - simply perfect. The term goldilocks economy is named after the golden-haired girl. It describes ideal conditions for emerging markets. Growth is strong, but it does not threaten to create imbalances and strong inflation that could prompt central banks to tighten sharply and withdraw monetary support.

This was the prevailing environment for several quarters before Donald Trump started the trade wars. Instead, in recent weeks, a large part of the market has begun to bet on a boiling porridge scenario. It involves out-of-control price pressures forcing the Federal Reserve to cut off the monetary stimulus, contrary to the mantra of repeated declarations. The effect is an increase in bond yields and a strengthening of the dollar. Yesterday's inflation data once again cooled such enthusiasm and resulted in a weaker dollar. Prices excluding fuel and food in January were unchanged compared to December and in February rose only marginally.

The euro dependent on the ECB

The weakening of the euro against the dollar has halted, and it is likely that short-term highs in the US currency's strength are near; much will depend on the outcome of today's meeting. We view the dollar's recent strength as a prolonged correction in the downturn that began last year.

The European Central Bank had been showing concerns about the euro's appreciation trend in previous months. This trend has stopped, but in its place, the worry has been the rise in government bond yields, which is also tightening financial conditions and threatening the already fragile economy. Some Governing Council representatives referred to it, and their statements almost came close to verbal interventions. Different problems - one solution: there were repeated suggestions of the possibility of cutting interest rates.

We believe that this is the last resort and that the tensions in the government bond market may be better alleviated by changes in the way the PEPP policy is conducted. This includes more intensive use of the program but also a change in the structure of the securities acquired. The ECB has more than half of the programme's total volume (EUR 1.85 trillion) left to draw, so there should be enough firepower. In addition, we will receive new forecasts for inflation and GDP. The prevailing narrative should be that the price hike is only temporary. In summary: today's meeting should not pose a threat of sharp declines in the EUR/USD pair.