EUR/USD, US Dollar Analysis and News:
- Hot Core Inflation Keeps a July Hike in Play
- Month End Flows Unwinding as Euro Recovers
EU DATA RECAP: Very Strong Core Inflation
Euro Zone flash estimate of inflation rose 7.5% Y/Y, matching consensus. However, the core figure printed notably above expectations at 3.5% compared to the 3.2% expected. As such, this will further fuel expectations that the ECB will begin to raise interest rates from July, where current market pricing is near fully priced in for lift-off. Meanwhile, Euro Zone Q1 GDP came in line at 5% Y/Y with a slightly softer than expected quarterly figure 0.2% vs 0.3% expected. That said, this is unlikely to deter the ECB from stepping up its plan to normalise monetary policy.
Market reaction to the data has been muted given that the figures are unlikely to notably move the needle for the near term outlook for ECB policy. Keep in mind that the bigger focus has been on Fed policy with markets positioning themselves ahead of next week’s meeting.
Modest USD Retracement as Month End Flows Fizzle
Elsewhere, as we approach the turn of the month, market participants look to be using this as an opportunity to fade the recent aggressive moves in the US Dollar. A reminder that in months where the US equities (SPX) fall at least 3% or more, the US Dollar tends to rise into month end before retracing the move in the first week of the new month. This is shown in the graph below. That being said, while most can agree that the USD is overbought, the issue has been the lack of alternatives with the greenback’s major counterpart (EUR) offer little to no reasons to be bullish. However, the currency I would watch is the Chinese Yuan, where a turnaround could suggest a possible USD peak.
Explainer of FX Month End Rebalancing
London WMR Fix (1600 London Time): The WMR Fix is one of the most widely used benchmarks for FX trading, taking place every day within a 5-minute window around 1600 London time. The fix provides a standard set of currency benchmark rates so that equity and bond investors can compare portfolio valuations and performance with each other.
The WMR fix tends to coincide with a sharp rise in trading volume, prompting a sizeable increase in liquidity. Occasionally, this allows for large real money flows to take place without causing too many distortions. However, flows can also be dominant in one direction (strong buying or strong selling) leading to outsized moves in a very short period of time.
The largest bout of volatility stems from the month-end fix, taking place on the last business day, where market extreme moves can often occur in the lead up during 15:00-16:00 London Time. These FX flows are derived from mostly equity rebalancing.
As such, if a UK portfolio manager holds US Dollar-denominated assets and seeks to hedge FX risk, then a monthly rise in the value of those assets will lead to more dollar hedging (selling the dollar). For example, if equities are FX hedged and US stocks (S&P 500) have risen on the month, while the FTSE 100 (UK stock market) has traded flat, then UK based investors would sell US Dollars against the Pound to add to their hedge, leading to an appreciation in GBP/USD. The greater the outperformance of US equity market over the UK would be associated with greater selling of the USD against GBP, prompting GBP to rise even higher. Although, extreme moves can often partially revert in the day following the month-end fix. That said, the occurrence of such event in a market as liquid as FX, suggests that the London fix (month-end fix in particular) is important for FX traders to watch for.
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