A much sharper than expected fall in euro zone inflation data for November weighed on the euro.

The first reason for this view, as we have discussed before, is that easing cycles that include the Fed are more likely to lower the US dollar, and so lift euro/dollar, provided this cycle is consistent with rising asset prices. In the Standard Bank’s view, it does not matter whether the ECB cuts rates sooner and/or by more than the Fed. As long as the Fed joins in and asset prices don’t crumble, the dollar should fall.

A second reason for this view has to do with inflation itself. In particular, the observation that there’s a very strong common global factor that runs through inflation in different countries. In other words, inflation tends to co-move and hence if we are seeing a notable fall in euro zone inflation we are more than likely to see the same in the US; something that could encourage speculation of faster and/or greater Fed easing than that currently priced into the market.

The observation of a common global factor in inflation rates is not a new phenomenon, but it has arguably increased. Globalisation has been a key reason for this and, while momentum here seems to have stalled, even before the pandemic, it is too early to tell whether this is going to create more country-wide divergence in inflation. A part of this global factor seems to be related to the fact that big changes in commodity prices, particularly energy, increase the co-movement between inflation rates, at least at a headline level.

While this is true it is also notable that inflation in the US and euro zone has co-moved pretty closely and yet energy price increases (following Russia’s invasion of Ukraine) have dominated in the euro zone, but not in the US, given the US’s relative self-sufficiency in energy. US headline inflation surged because of other ‘temporary’ factors, such as used car prices.

However, if we try to remove these outliers like energy from the euro zone or used cars in the US, by looking at trimmed mean inflation rates, we still see a strikingly similar performance between the US and euro zone. Some might blame this strong co-movement in inflation on labour market tightness, which is common to both and, indeed, common to other developed countries. However, it is not as if countries that have significant labour market slack have avoided a surge in inflation. So here too, this common global factor that we talk about in driving inflation across countries seems pretty impervious to labour market conditions.

In sum, it seems to us that inflation is most likely to co-move quite closely between major countries/regions, such as the euro zone and the US. And this means that if there’s no ‘stickiness’ in euro zone inflation that keeps inflation above target for an extended period of time, we are likely to see the same in the US – and other countries. And if the money markets are starting to clamour for an early rate cut from the ECB they are likely to do the same thing in the US and elsewhere.

This does not necessarily imply that major central banks will start their easing cycles at the same sort of time as inherent anti-inflation biases within the various central banks will probably allow for some divergence in the rate-cut schedule. But this does not really matter when it comes to euro/dollar or the dollar against other currencies.

For provided this common factor is pulling US inflation down in a similar way to elsewhere, and provided the Fed remains on course to reduce rates at some point, the dollar is still likely to fall. The crucial requirement, that we mentioned earlier, is that any easing of Fed policy occurs against the backdrop of stable-to-stronger global asset prices for, if asset prices slump, the dollar’s safe-asset qualities will dominate any rate-cut argument and produce a stronger dollar.

Perhaps counterintuitively such a scenario could be more likely if inflation falls very fast indeed as this would hint at monetary overkill from the central banks and presumably hit risk assets like equities hard. Fortunately, though, this is not the scenario that the Standard Bank expects to unfold.