EUR/USD: Euro steadies after Italy curtails windfall tax and ahead of US CPI

• Italy cushions windfall tax blow
• China deflation to spark stimulus efforts
• US five-year inflation breakeven nears peak set in April 2022

Yesterday, the euro took a big hit after Italian Premier Meloni’s cabinet approved a 40% levy on lenders’ extra profits.  Today was all about damage control as the Italian government had to tweak and ease up this crushing windfall tax on banks. The initial tax plan crushed the European banking sector, but that might see some relief now that the finance ministry clarified that the levy won’t surpass 0.1% of a firm’s assets and that banks who have delivered increased interest rates to depositors won’t be greatly impacted. The euro was steadying earlier, but a recovery of yesterday’s losses seems unlikely.

The FX market appears to be struggling for major moves ahead of the US inflation report and that is somewhat surprising considering the deflationary numbers that came from China last night.  China saw both consumer and producer prices decline together for the first time since early in the pandemic.  China’s producer prices have been steadily dropping for 10^th consecutive months, which should support disinflation hopes from most of the advanced economies.  China’s core CPI is still in positive territory, but that shouldn’t prevent officials from being a little bit more aggressive with stimulus.

Even with China’s falling prices, some investors are still not yet confident that US inflation will come all the way down to the Fed’s target.  One of the long-term inflation gauges, the US five-year inflation breakeven remains elevated and close to the high made in April 2022.  Tomorrow’s inflation report could send this long-term measure above 2.5% or cool the steady rally that took hold since June.

US five-year inflation breakeven chart

Leading up to the US CPI report, EUR/USD has been consolidating between the 1.0920 and 1.1040 levels. Any significant upside surprises could support a stronger dollar, which could trigger a tentative break down below 1.0940 short-term support level.  An in-line inflation report could see the current trading range hold up, while a cooler-than-expected might support a rally towards the 1.1100 handle.