Market Explainer: trusting the Fed, as Lagarde keeps her steady hand

As we move to the end of the week, the markets are digesting some important information that could determine the direction of markets for the medium-term. US CPI surprised on the upside, yet risk sentiment is holding up well.

The ECB confirmed its “very accommodative monetary policy stance”, while keeping policy on hold on Thursday. ECB president Lagarde said that she would sum up Thursday’s meeting as the ECB keeping a steady hand, as growth and inflation figures were revised up for 2021 and 2022. Lagarde was clear that she is not willing to start tightening even though the balance of risks to the Eurozone economy has been reduced to “balanced” from high, and that she would watch euro strength in case it disrupted the ECB’s inflation target.

Markets ignore rising US inflation

Overall, financial markets are generally stable. As mentioned above, financial markets have taken the highest annual inflation rate in the US for nearly 13 years, after headline cpi surged to 5% last month, in their stride. The price of used cars, furniture, airline fares and apparel were the main drivers of sharply rising prices in May.

Interestingly, the bottleneck with the delivery in microchips that has been reported widely in recent weeks could drive the price of used cars higher in the coming months, with the US and Europe likely to be impacted. Considering used car prices jumped more than 7% last month, upward pressure on prices is likely to be here for some time. Central banks continue to confirm that they are not going to react to the “transitory” impact of price pressures. This is the line that the Federal Reserve has stuck to consistently in recent weeks, with Fed chair Powell saying that price pressures will be transient, and it’s the impact of industries adjusting to the effects of Covid such as higher prices for shipping and containers, a shortage of parts, and the price pressures linked to the re-inflation trade after global Covid lockdowns.

In a similar vein, ECB President Lagarde wasn’t too worried about price increases as she expects the bottlenecks to lead extra private sector capacity which will ultimately drive prices down in the medium term.

Why central banks are sanguine on inflation

The concept of the medium term is important when it comes to central bank decision making. Policy makers tend to set policy with the future in mind, say a 2-year time horizon. Thus, the fact that the ECB’s inflation forecasts were revised higher for 2021 are unlikely to impact policy, instead it is what is forecast for 2-3 years’ time that really matters.

Core inflation, which strips out volatile elements like food and energy, is expected to rise from 1.1% this year to 1.4% in 2023, which is well below the ECB’s target rate of 2%. During her press conference ECB President Lagarde was asked if she would consider boosting asset purchases to raise core inflation to the ECB’s target rate of 2%, however, she said this was unnecessary because of price pressures that are already building in the global economy.

This comment from the ECB is worth noting as it suggests that the ECB is happy with price pressures the way that they are, and it is confirmation yet again that the major central banks are unlikely to react to rising prices. This is one reason why Treasury yields have actually fallen in the aftermath of this CPI report, the 10-year Treasury yield fell below 1.5% on Thursday, and why tech stocks moved higher at the end of this week.

In the FX space, the dollar index is likely to remain subdued for some time, even if the dollar index is able to remain above the key psychological 90.0 level for now. Price action after the US CPI data reinforces the idea that investors are starting to believe the Fed and they are not reacting in the same way to higher US inflation data as they did to the stronger CPI report for April, and this is likely to support asset prices in the medium term.

Market ideas: Dow Jones index

In terms of trade ideas, this leaves us with fairly stable markets for June, which tends to be a quiet month for equities as there is dearth of earnings releases and central bankers are unlikely to change policy any time soon. When the fundamentals are sparse, it’s time to look to the technical indicators. From a technical perspective we favour the Dow Jones over the Nasdaq, for a few reasons.

Firstly, the medium-term outlook for the Dow remains bullish, based on key technical indicators. After a strong recovery run after its Covid-related sell off last year, the index has paused for breath recently. We believe that this is a healthy move, and it has allowed the index to move out of overbought territory. Thus, traders may wait until there is a confirmed break above 33,800 to signal the next leg higher for this index. Key resistance, once this level is broken, is 34,600 in the medium term. In contrast, the Nasdaq has been trading sideways for some time which leads us to think that demand is patchy and that the future direction for the US’s tech-heavy index could be inconsistent.

We believe that there will need to be a break of all-time highs above 14,100 for traders to get excited about further upside for the Nasdaq in the medium term.

FX: EUR outlook

In the FX space, we are looking closely at the euro, after the ECB said yet again that it was watching movements in the currency closely, however, it would only act if there was a threat to inflation. Since the ECB is looking at core inflation rates in two years’ time that are below the 2% target rate, then a strengthening euro could be something that the ECB chooses to target in the coming months. Any action to talk down the euro by the ECB may be pre-empted by the market in the medium term, and we believe that further euro downside could be in store.

While EUR/USD downside could be hampered by the weakness of the US dollar, we think that EUR/GBP could see further downside as both the technical and fundamental indicators suggest further GBP upside is available. A confirmed break of 0.8600 in EUR/GBP opens the way to further downside towards 0.8550, which is the bottom of the 2-month range for this pair. This is key support and if it is broken then we could see a further decline towards a break of 0.8500 in the coming days and weeks. Overall, we don’t think that the euro will be able to gain much traction against the pound in the coming weeks, and that could trigger further downside.