HomeInflation Divergence On the Two Sides of the Atlantic Ocean

Inflation Divergence On the Two Sides of the Atlantic Ocean

6 October 2020 By Mircea Vasiu

The currency market moves depending on how inflation evolves during a certain period. Despite perceived as having a negative impact on society, certain inflation levels are desirable for strong economic growth. 

In other words, not all inflation is bad, but certainly, low inflation is bad. Most central banks in the developed world have an inflationary target, aiming to create inflation below but close to two percent.

Core inflation refers to the changes in the price of goods and services over a specified period, excluding some volatile items. Such items usually refer to oil, transportation, and anything that relates to energy prices. In some cases, also food is considered volatile enough not to be included in core inflation’s definition.

Core Inflation Differential Between the U.S. and the Eurozone

When trading financial markets, different trading styles exist. One of them is to trade based on interpreting macroeconomic trends, changes in monetary policy, or economic developments. While it takes longer for a trade to bear fruits, some of the greatest trades in history were fundamental, not technical. For instance, when George Soros “broke” the Bank of England, forcing it out of the Exchange Rate Mechanism, the trade paid over a billion dollars in profit. Soros correctly interpreted the fundamentals between the British Pound and the ERM and built his trade accordingly.

Therefore, the source of a fundamental trade can appear from anywhere. In this case, the core inflation differential between the United States and Eurozone shows the potential of a divergence between the monetary policies.

The Fed in the  United States only announced the shift to an Average Inflation Targeting. On the other hand, the ECB is yet to make a decisive move on the back of 0.2% inflation in September.

While the Fed reacted with a dramatic move, the ECB, in a traditional European style, lags. But that does not mean that the USD will appreciate against the Euro or the other way around. Instead, it shows different data for two of the most important central banks in the world. A trader’s job is to interpret the data, to put together the central banks’ actions, and to act on the information via a trade.

Unlike technical analysis, fundamental analysis needs time for the effects of a central bank’s decision to appear on the market. It means that the fundamental trader needs different risk management tools than the technical one – which makes fundamental analysis more interesting on so many levels.

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