The dollar index made a new high for the year yesterday, 3.8% higher than the level seen at the start of the month. This follows on from two sessions of downward pressure on the dollar, which was more down to the extent of short positioning on some of currencies under pressure for most of the month. As we start the European session, EUR/USD itself is not that far off the lows for the year at 1.2624 as EU leaders meet for an informal summit in Brussels. Germany is looking increasingly isolated with its austerity - with no Plan B stance - and continues to rule out any sort of common debt for the eurozone. This summit is designed to shape the plans around the next formal summit at the end of June, so don’t expect any major statements, but the surrounding comments will be key in shaping the debate ahead of that meeting. For now, currencies look set to reflect the theme of dollar dominance once again, with stock markets seen heading lower in Europe after the recent breather.
Sterling’s resilience. Sterling took a tumble yesterday on the back of the latest inflation numbers, which showed the headline rate declining a touch more than expected to 3.0% in April, from 3.5% previously. This puts inflation back onto the downward trajectory that it started on back in December of last year, but was interrupted by the March numbers. Half of the decline in the YoY rate came from transport prices, some of this owing to the timing of Easter and its impact on air fares. The pace of annual inflation fell in just six of the 12 categories, showing that disinflationary forces are not spread across the whole economy. The other point to note is that the fall in core inflation was more modest than expected, down to 2.1% from 2.5%. Does this mean that the Bank is poised to offer more QE? We might get some more indication on this with the minutes of the May MPC meeting of today. There remains however a fairly wide split of opinion on the MPC at present and the other factor to bear in mind is that the MPC has consistently over-estimated the downward impact on inflation from the weakness in the economy. It is also far from conclusive that further QE would help stimulate given the naturally diminishing returns, especially with Gilt yields already so low. From this perspective, the sterling reaction to the numbers looked a little overdone and this was underlined by the subsequent recovery seen vs. the dollar. We are, for the moment at least, in choppy waters on the FX front.
The pressure on Merkel from both sides. Under huge pressure from most of the rest of Europe to agree to the issuance of eurobonds as a way of circumventing the Continent’s sovereign debt crisis, it turns out that the German Chancellor now faces similar pressure at home. The Opposition Social Democrats are urging her to consider Deutschland bonds – its argument is that some form of shared debt-liability with the federal government is reasonable as the states have constitutional budget limits they are required to meet. If Merkel were to accept this proposal then the states would benefit from much lower funding costs. A meeting is due to be held on Thursday with the Social Democrats – she needs their support to get the fiscal pact and ESM legislation through the Bundesrat (upper house). The Social Democrats have set out their stall, wanting clarification on what exactly is required from the states, and seeking Merkel’s imprimatur (at least in principle) to this Deutschland-bonds proposal. To put this into perspective, state debt is roughly one half of the federal government’s EUR 1.1trln debt. It turns out that Merkel is sympathetic to the idea, in stark contrast to her extremely limited enthusiasm for eurobonds. Just perhaps she trusts German states to deliver fiscal discipline much more than she does Europe’s southern sovereigns. Based on recent history, her scepticism is perfectly understandable.