Credit Agricole

Stagflation Becoming A Major Theme

Stagflation has become a major theme for FX markets. The extent of stagflation an economy is experiencing can be measured by the misery index (the sum of their inflation and unemployment rates). This index also measures how much damage central banks will have to inflict to get inflation back under control. Indeed, the YTD performance of G10 currencies tends to be inversely related to their misery index.

Fear of stagflation is part of what is ruining the EUR and GBP. While the ECB tried bravely to support the EUR this week, its weak growth forecasts and Europe’s energy crisis hardly make a credible argument for currency strength. And while Prime Minister Liz Truss’ fiscal stimulus pledges can boost the economic outlook, the UK economy suffers from similar problems to the Eurozone, plus Brexit-related supply shortages. Moreover, the spending plans of the UK government have threatened to upend the gilt market at a time when the country’s external imbalances are deteriorating. In turn, this can complicate the BoE’s own gilt sales plans that are set to start this month with any potential delays likely to keep UK real yields deeply negative. In turn, this could offset the positive GBP impact from any aggressive BoE rate hike next week.

The standout exceptions to the misery rule are the USD and JPY. The US’s misery index is mid-range in the G10, but the USD’s performance has been outstanding. The USD’s appeal as the safe port in any storm helps explain this. Japan’s misery index is the lowest in the G10, yet the JPY’s performance is the worst in the G10. Even Japan’s policymakers are beginning complain about the pace of the JPY’s slide. Without a change in tack by the BoJ, any FX intervention would at best only slow the JPY’s depreciation.

Several G10 countries will update their misery indexes this week with inflation readings in the Eurozone, Switzerland, the UK and most importantly the US. Strong inflation readings may not be positives for the EUR and GBP as they could further aggravate stagflation concerns. A high US inflation number could trigger risk-off trading and higher UST yields and be positive for the USD. US retail sales data will be a gauge of how strong growth remains despite higher rates and living costs. Australia’s unemployment rate will update its misery index; the main constraint on job creation remains the availability of workers.

EUR

The war in Ukraine has fanned stagflation headwinds in the Eurozone and should further have lasting consequences for the Eurozone’s international competitiveness, external position, relative real yields and commodity terms of trade. The ECB has embarked on policy normalisation in the face of these risks. The vulnerability of the Eurozone periphery in the face of diminishing monetary support further complicates its task. That said, we think that the ECB should ultimately be able to contain spikes in Eurozone credit risks. This, coupled with the removal of ECB negative rates, should make the EUR a more attractive safe-haven currency from here and help it benefit from repatriation of funds held abroad back into the Eurozone. Many negatives seem to be in the price of undervalued and oversold EUR/USD and the pair could stabilise close to recent lows in the coming months.