FX Daily: Omicron presents stagflation risks

DXY and EUR to struggle against each other
Philip Wee01 Dec 2021
    Photo credit: Unsplash Photo

    DXY and EUR are struggling against each other on above-trend inflation. The Fed and the European Central Bank face pressure to step up plans to normalize monetary policy at their meetings on 15 and 16 December respectively. Assuming the US 10-year treasury yield is supported at 1.40% on the Fed and capped at 1.70% by Omicron, DXY might consolidate between 95.5 and 97.0, and EUR between 1.12 and 1.14. The sell-off in stock markets resumed on Tuesday on Moderna’s prediction that existing vaccines will be less effective against the more contagious Omicron strain. However, it will be weeks before health experts have sufficient data to confirm how much this is true and if Omicron is a milder or deadlier variant. Until we know more, countries are choosing travel restrictions and border closures over lockdowns and strict restrictions at home.

    During the testimony to the US Senate Banking Committee, Fed Chair Jerome Powell acknowledged that it was time to drop the term “transitory” regarding inflation and appropriate for the Fed to discuss accelerating tapering asset purchases. Powell’s comments were consistent with US Treasury Secretary Yellen’s recent remark that containing the pandemic will contain the supply disruptions fuelling inflation. Simply put, Omicron could keep inflation high for longer. However, Powell did not rule out inflation falling again in the second half of next year. WTI crude oil prices fell more than 20% from their peak of USD84.65 per barrel in October to USD66, close to a potential support at USD63.30, the low in August. Accelerating the taper hinges on the Fed’s assessment of the US economy which is currently strong. The Atlanta Fed GDPNow index projects US GDP to rebound by an annualized 8.6% QoQ in 4Q. However, Powell also recognized that Omicron posed downside risks to the US economy. The fall in the US consumer confidence index to a nine-month low of 109.5 in November cautioned against complacency regarding the ability of households to cope with high inflation.

    In the Eurozone, Germany’s incoming chancellor Olaf Scholz and outgoing Bundesbank President Jens Weidmann sent strong signals for the ECB to prioritize price stability again instead of focusing policy to fund indebted countries. Scholz linked rising inflation to government spending, not just higher energy prices. Eurozone’s core CPI inflation increased to 2.6% YoY in November, decisively above the official 2% target. Headline inflation was significantly higher at 4.9% and 6.0% for the bloc and Germany respectively. Moreover, Omicron has cast doubts on ECB member Isabel Schnabel’s view that inflation might peak in November. Although many ECB officials are toeing the “transitory inflation” stance, some have recognized the risks to inflation are skewed to the upside and becoming more structural from supply constraints. Hence, pay attention to ECB President Christine Lagarde and Chief Economist Philip Lane this Friday. While no one expects them to pivot like Powell, they will need to acknowledge that Omicron can keep prices high for longer and slow the return of inflation to its 2% target despite the downside risks to the economy.

    Philip Wee

    Senior FX Strategist - G3 & Asia
    [email protected]

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