Monex Europe: China’s growth prospects increasingly supportive for euro

January 11, 2023

By Simon Harvey, Head of FX Analysis, Monex Europe

The recent rally in EURUSD has been driven by two factors: 1) improving growth conditions outside of the US and 2) a hesitancy by markets to believe the Fed’s forecast of no rate cuts later this year. A narrowing in growth differentials and more dovish pricing of the Fed relative to their own projections is the inverse of the dynamics that propelled the dollar’s meteoric rise in 2022.

A narrowing in growth differentials
Over the past few weeks, growth outlooks in both the eurozone and China have improved dramatically, while soft survey data in the US points towards an imminent slowdown in hard data. In the eurozone, the improved growth outlook has been driven almost solely by the stabilisation in spot energy prices at low levels relative to Q3/Q4 2022 due to lower seasonal demand following a more moderate winter. The lower spot gas prices have helped, in tandem with lower overall energy demand, in rotating energy demand from the withdrawal of gas from storage to spot gas markets. This has resulted in the decline in eurozone gas storage levels plateauing at around 80% of full capacity, some 13.5% higher than the average level for this time of the year. The plateau in the drawdown of Europe’s gas inventories reduces the projected supply shortfall Europe will find itself needing to plug during the middle months of this year as it seeks to rebuild inventories ahead of the 2023/24 heating year. The reduction in the estimated supply shortfall not only lowers the likelihood of economically restrictive energy rationing measures being imposed but also the peak that European gas prices can reach in the middle months of 2023 as nations are forced into more expensive global energy markets. This will not only reduce the inflation impulse from energy markets but also the impact of China’s economic reopening on the eurozone current account deficit in 2023. Instead of competing against a stronger Chinese economy in relatively tight global LNG markets, as eurozone nations can rely on inventories, the impact of China’s reopening surge this year on eurozone growth conditions may become net positive again with the impact of stronger export demand outweighs the impact of higher energy prices. The likely size of this growth impulse has only increased over recent weeks too as Chinese officials have signalled that they intend to support the economic recovery through a variety of fiscal, monetary and regulatory means. Not only have China’s stronger growth prospects become increasingly supportive for eurozone growth conditions, provided energy storage levels aren’t reduced much further, they have also boosted overall risk conditions, helping beleaguered eurozone assets to recover and thus support capital inflows into the eurozone.

The overall improvement in global growth conditions outside of the US has contrasted heavily with soft survey data from the US which suggests the economy is starting to considerably slow. Not only has this supported outflows from US capital markets, but it has also eroded the markets belief that the Fed will be able to hold rates at the estimate 5-5.25% peak for the entirety of the second half of 2023.

Eurozone gas inventories are tracking above historical averages at this point of the heating season

Markets are calling the Fed’s bluff
While Friday’s net payrolls figure of 223k helped to allay fears that the US economy was sliding into an imminent recession, especially given the concentration of job gains within typically cyclical industries, forward looking indicators such as the ISM survey measures of services and manufacturing activity suggest that the US economy is started to slow at a considerable rate. Not only that, but cooling wage pressures in the US labour market suggest that core services inflation is set to cool in the coming months given that the wage bill accounts for a large proportion of most service sector input costs. The combination of a slowdown in US growth and reduced core inflationary pressures in recent data has meant that markets are starting to call the Fed’s bluff that they will hold rates at their peak for the remainder of 2023.

Market pricing for Fed easing in H2 2023 is near record levels despite all Fed officials denying the likelihood of rate cuts

Risks are tilted to the downside as EURUSD eyes its Q1 2022 range
While the pendulum begins to swing for EURUSD as it climbs towards its Q1 range of 1.08-1.15, risks are heavily tilted to the downside. Firstly, a lot still depends on Europe’s weather conditions for the remainder of the 22/23 heating season. This is exemplified by weather forecasts just six months ago which predicted below-average temperatures. Below-average temperatures between now and the seasonal trough in Europe’s gas storage in April could well widen Europe’s projected energy supply shortfall again. This would reverse the impact of China’s stronger growth outlook on the euro’s economic fundamentals, inducing a unique inverse correlation between China and Europe’s growth outlook. Additionally, markets could come back around and believe the Fed’s forecasts. Thursday’s inflation data holds the key for that in the near-term. Any stagnation in the progress of US disinflation or signs that persistence in core inflation pressures have re-emerged could easily flatten the June 2023 – December 2023 US OIS spread and send EURUSD back down to 1.05-1.06 ranges.

In short

• Not only have China’s stronger growth prospects become increasingly supportive for eurozone growth conditions, provided energy storage levels aren’t reduced much further, they have also boosted overall risk conditions, helping beleaguered eurozone assets to recover and thus support capital inflows into the eurozone.
• The combination of a slowdown in US growth and reduced core inflationary pressures in recent data has meant that markets are starting to call the Fed’s bluff that they will hold rates at their peak for the remainder of 2023.
• While the pendulum begins to swing for EURUSD as it climbs towards its Q1 range of 1.08-1.15, risks are heavily tilted to the downside.
  • A lot still depends on Europe’s weather conditions for the remainder of the 22/23 heating season. Below-average temperatures could reverse the impact of China’s stronger growth outlook on the euro’s economic fundamentals, inducing a unique inverse correlation between China and Europe’s growth outlook.
  • Markets could come back around and believe the Fed’s forecasts. Thursday’s inflation data holds the key for that in the near-term.