Latest / The Macro Memo with Fexingo: Daily Conversations on Inflation, GDP, and Federal Reserve Policy / The ECB Exit Puzzle and What It Means for the Dollar
Transcript
- Lucas: So the euro has lost about three and a half percent against the dollar since the beginning of June, and this week it touched its lowest level since late 2022. That move is getting less attention than it deserves, because it's quietly reshaping the inflation outlook for both sides of the Atlantic. Luna: Is the main driver the Lagarde comments from last week? Because she definitely left the door open to an early rate cut, and that usually weakens a currency. Lucas: That's the spark, but the fuel is French political uncertainty. Lagarde said the ECB could exit its tightening cycle sooner than expected if the economic outlook deteriorates, and she specifically mentioned French fiscal risks. Markets heard that and immediately priced in a higher probability of a September cut. Luna: And meanwhile the Fed is just sitting at 3.63 percent, not budging. So the rate differential widens, dollar gets stronger, euro gets weaker. Lucas: Exactly. The Fed funds rate is effectively flat, and the market doesn't see a cut until maybe December at the earliest. So you've got the ECB potentially easing while the Fed holds, and that interest rate gap is the single biggest driver of currency moves right now. Luna: But here's the thing — a weaker euro should mean cheaper imports for the eurozone, which helps their inflation problem. But for the US, a stronger dollar makes imports cheaper too, which actually helps the Fed's inflation fight. So shouldn't the Fed be happy about this? Lucas: They're not unhappy, but it's not that simple. A stronger dollar does lower import prices, but it also hurts US exporters and can weigh on manufacturing. And the bigger story is what this says about global demand. The euro weakening is partly a vote of no confidence in European growth, and that's a headwind for the global economy. Luna: Right, because if Europe slows down, that's less demand for US exports too. So the net effect on the US might be neutral or even slightly negative. Lucas: Exactly. And look at the bond market. The ten-year Treasury yield is at 4.57 percent, up about nine basis points over the past week. Some of that is repricing of Fed expectations, but a lot of it is the dollar strength itself. Foreign investors buy Treasuries, and a stronger dollar makes those returns even more attractive, which pushes yields down. But we're seeing yields rise anyway, which tells you the market is worried about something else. Luna: The breakeven inflation rate ticked up to 2.24 percent. That's not a huge move, but it's up from 2.23 last week. So inflation expectations are creeping higher even as the dollar strengthens. Lucas: That's the puzzle. Normally a stronger dollar suppresses inflation expectations. But if the dollar is strengthening because of rate differentials, not because of stronger US growth, then the inflation picture gets muddled. The ten-year breakeven has been stuck in a range between 2.20 and 2.30 for months, and it's starting to push toward the top of that range. Luna: And if the ECB does cut in September, that divergence widens even more. The euro could fall further, which would make US imports even cheaper, but it could also make European exports more competitive, which might actually help their economy. It's a complicated feedback loop. Lucas: It really is. And this is one of those moments where the currency market is telling a story that the equity market isn't fully pricing in yet. The S&P 500 is at 7,575, up half a percent over the past five days. That feels complacent to me, given what's happening in Europe and what it means for global trade. Luna: You think the equity market is ignoring the euro weakness? Lucas: I think it's not fully connecting the dots. A weaker euro means European earnings get a translation boost when reported in dollars, so that's a positive for European stocks. But for US multinationals with exposure to Europe, their earnings take a hit. And if European growth slows, that's a demand shock. The Russell 2000 is already down over one percent in the past five days — small caps are more domestically focused, so they're less exposed to currency, but they're also more sensitive to the economic cycle. Luna: Speaking of the labor market, we got the JOLTS data this week showing job openings ticked up slightly to 7.594 million. That's still historically high, but the trend is clearly down from the peak. And the unemployment rate fell to 4.2 percent, which is good news, but the payrolls number was only 57,000. That's weak. Lucas: Yeah, that payrolls number really stood out. 57,000 jobs added in June is well below the trend. And the labor force participation rate fell again, which the show has talked about a lot. People are leaving the workforce, and that's putting upward pressure on wages — average hourly earnings are up to 37.60, that's about 3.5 percent year-over-year. Luna: So the Fed has a mixed picture: wage growth is still too high for comfort, but job creation is slowing. The dollar is strong, which helps on imports, but inflation expectations are edging up. It's no wonder they're on hold. Lucas: And the ECB situation adds another layer. If the euro keeps falling, that's deflationary for the US in the short term, but it also increases the risk of a global slowdown. The Fed might have to cut not because inflation is under control, but because growth is faltering. And that's a different kind of easing cycle. Luna: Which brings us back to the bond market. The two-year yield is at 3.69 percent, down a bit on the week. That's the market pricing in rate cuts eventually. But the long end is rising, which is the term premium repricing. The yield curve is steepening, but not in a healthy way. Lucas: Right. A steepening curve is normally a sign of economic optimism — long-term rates rise because growth expectations improve. But in this case, long-term rates are rising partly because of inflation fears and supply concerns, not because of strong growth expectations. Real GDP growth came in at 2.1 percent annualized for the first quarter, which is solid, but it's decelerating from 2.5 or so in the second half of last year. Luna: If walking through these connections with us has been useful, that's exactly why we keep the show ad-free. If you find value in these daily conversations, you can support the show at buy me a coffee dot com slash fexingo. It helps us keep doing this. Lucas: Yeah, absolutely. No pressure, but if you get something out of it, that's the way to keep it going. And honestly, knowing people are listening carefully enough to follow these threads — that's the best part. Luna: So back to the euro — what's the key level to watch? If it breaks below 1.03 against the dollar, that's a psychological line that could trigger more volatility. Lucas: I think 1.03 is the big one. It hit 1.04 this week, so we're getting close. If that breaks, you could see a quick move to parity. And that would be a huge deal for inflation — a 10 percent decline in the euro adds about half a percent to US import prices over a year, but it's delayed. So the disinflationary benefit today might be followed by some reflation down the road. Luna: Which is exactly what the Fed doesn't want — inflation coming back after they've declared victory. That's why they're being so cautious. Lucas: Exactly. The ECB decision is a moving piece that affects the Fed's calculus, even though it's half a world away. These cross-market connections are what make macro so fascinating. One central banker in Frankfurt says something about French politics, and suddenly the entire US yield curve shifts. Luna: And the French election uncertainty isn't going away anytime soon. The second round is coming up, and if the far-right or a left-wing coalition gains ground, that could spook markets further. Lucas: Yeah, that's the wildcard. Lagarde's comments were partly a response to that political risk. If the next government pursues fiscal expansion, the ECB might have to keep rates higher to offset the inflationary effect. But if there's a crisis of confidence, they might have to cut to support growth. It's a lose-lose in some ways. Luna: So for investors, the takeaway is that currency exposure matters more than it has in years. And maybe diversification into non-dollar assets makes sense if you think the euro stabilizes. Lucas: I think that's right. The dollar has been strong for a long time, but the euro at these levels is pricing in a lot of bad news. If French political risk fades, the euro could bounce sharply. And that would mean a weaker dollar, which would change the entire inflation and rate outlook. So it's worth watching. Luna: Alright, tomorrow we'll talk about what the Chinese inflation data means for global commodity demand. Producer prices there are rising, but consumer prices are weak — that's a strange mix. Lucas: Perfect. That one ties right into this global story. See you then.