The euro slipped lower against the U.S. dollar Friday as a closely-watched measure of currency area inflation missed analysts' forecast in a reading that could have significant implications for U.S. interest rates.
Eurostat, the region's official statistics office, said consumer prices around the 19 countries that use the European single currency accelerated by an annual rate of 2% in August, modestly faster than the European Central Bank's 'just below 2%' target but down from a 2.1% reading in the previous month. So-called core inflation, however, which strips out volatile prices for food and energy, as well as state-controlled alcohol and tobacco products, was estimated at 1%, down from a reading of 1.1% in July and just shy of economists' forecasts.
The reading pushed the euro around 0.05% lower against the U.S. dollar at 1.1663 immediately following the release, as investors worried that slowing growth in the region would tame consumer prices and potentially delay the interest rate hikes signalled by the ECB for September of next year.
However, if inflation were to slow even moderately over the next few months, while investor concern over the looming fiscal showdown between Italy and European Union officials in Brussels intensifies, investor moves into safe-haven assets outside of the Eurozone could hold down U.S. Treasury bond yields and complicated the Federal Reserve's own plans to raise interest rates in the months ahead.
Benchmark 10-year German bond yields, a proxy for risk-free interest rates in the Eurozone, were marked at 0.358% Friday, giving investors the chance to take a stronger currency (one euro buys 1.16 U.S. dollars) and purchase 10-year Treasury notes that yield 2.85%. That's a 2.492% return swing into one of the world's most liquid markets adds no risk to a particular portfolio.
It's all in the numbers: #equity prices do not get sufficient support from the economy. #Reflation is not yet feeding through to bond prices. Quite the contrary; the US yield curve appears to be becoming inverse https://t.co/aacauLJysI #ChartoftheWeek pic.twitter.com/UQVjWUKHu2— AllianzGl (@AllianzGI_view) August 31, 2018
The attraction of that trade was party on display earlier this month, when Treasury International Capital data showed a net increase in foreign purchases of U.S. assets neared $420 billion in the second quarter, with June inflows of $114.5 billion.
That dynamic alone is strong enough to keep 10-year yields firmly below the 3% threshold, while the Fed's signalling of gradual rate hikes continues to push two-year bond yields higher -- the CME Group's FedWatch tool suggests traders are pricing in a 70.1% chance of a December move that would take the FedFunds rate to between 2.25% and 2.5% -- and keep the so-called yield curve at the 'flattest" since 2007.
"When the curve does invert, possibly around mid-2019, a recession may not necessarily be around the corner," said ING strategist Martin van Vliet. "However, the message from a flat/inverted curve shouldn't be ignored, as it could hurt banks and the process of credit creation, potentially making an economic downturn self-fulfilling."