Euro extends rally as inflation sinks

The euro is on a tear, climbing almost 2% since Thursday. Earlier today, EUR/USD rose to 1.0731, its highest level in a month.

Eurozone inflation falls sharply

Germany and other eurozone members recorded lower inflation in December, and eurozone inflation was expected to also soften. What was surprising was the extent of the drop, with headline CPI falling to 9.2%, down from 10.1% and below the estimate of 9.7%. This sent the euro sharply higher on Friday.

The main driver of the decline in inflation was a drop in oil and natural gas prices, as well as energy subsidies. It’s looking increasingly likely that inflation has already peaked, but of course, the road back to the 2% target will be a long one. The ECB’s latest projection shows inflation won’t hit this target until 2025. Another caveat is that core inflation actually rose in December to 5.2%, up from 5.0%, which was also the forecast. With core inflation remaining persistent, it’s likely that the ECB will remain hawkish in the first quarter and rate hikes of 50 basis points are likely in February and March.

The eurozone Sentix Investor Confidence index climbed for a third straight month, rising by 3.5 points in January. Investor expectations improved, with hopes that the reopening in China will boost the eurozone economy. Still, the index is mired in negative territory, at -17.5 points.

In the US, the data was mixed on a busy Friday. Nonfarm payrolls came in at 223,000, down from 256,000 but above the estimate of 203,000. This was a decent release, but investors chose to focus on the soft releases. Average hourly earnings rose 4.6%, well off the 5.0% estimate and shy of the prior reading of 4.8%. As well, the ISM Services PMI fell into contraction territory for the first time since May 2020. The index slipped to 49.6, down sharply from 56.5 and the forecast of 55.5. The drop in wage growth and weaker services activity could force the Fed to rethink its aggressive rate policy and even cut rates late in the year. This has raised risk appetite and sent the US dollar lower across the board.

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EUR/USD Technical

• EUR/USD has support at 1.0702 and 1.0612
• There is resistance at 1.0800 and 1.0953

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