The ECB's Role: Lifeline or Trampoline for EUR/USD Amidst Rate Hike Speculation
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ECB may be a lifeline not a trampoline for EUR/USD
September’s ECB meeting will be a binary risk event for the euro. Our baseline scenario sees a rate hike, which would translate into a stronger euro in the aftermath of the announcement, as market pricing is leaning in favour of a hold. But with EUR/USD having been on a steady bearish path since the 1.12 July peak, the real question is whether a hike would invert the trend. The short answer is probably not, but there are some important considerations to make.
First of all, it’s worth explaining why we think the FX impact of an ECB hike will be short-lived. One key reason is pricing: markets have doubted the ability of the ECB to hike this week (9bp priced in), but are still factoring in a total of 17bp of tightening to the peak by year-end. Arguably, the ECB hawks won’t have much interest in delivering one hike this week and striking a dovish tone, as the effective tightening via rates would be limited, so they should accompany a hike with openness to do more. However, with economic conditions deteriorating fast in the eurozone and dovish dissent within the ECB growing, it will be hard to convince markets to price in any additional tightening.
When we look at the 2-year swap rate spread between the euro and the dollar, an important driver of currency fluctuations, we can tell that it has recently approached the -125bp support level (five central bank “lengths” between the Federal Reserve and ECB). Let’s remember that the swap rate tells us the expected average rate for the next two years, so includes expectations for the final moves in the tightening cycle (if any) and rate cuts. What has really driven the recent widening of the spread in favour of the dollar has not been any repricing higher in Fed rate hike expectations, but a downsizing of easing bets in the US for next year.
EUR/USD and short-term swap spread
With rate hike cycles coming to an end, swap rates are increasingly sensitive to expectations about the timing and pace of easing cycles. Those expectations are, however, far less controllable by central bank communication, and much more dependent on data.
But can the ECB at least show signs of a united hawkish front and convincingly push back against rate cut speculation? (The first ECB cut is priced in for July 2024). If it can, then you have a trampoline for a sustainable EUR/USD rebound, otherwise – and we really think this will be the case – the best President Lagarde can do for the euro is to offer a lifeline.
One way the ECB could, however, end up having a longer-lasting FX impact is via an acceleration in quantitative tightening. However, that obviously comes with non-negligible risks to peripheral spreads, and policymakers may want to tread quite carefully in that sense.
After the short-term impact, EUR/USD should revert to being driven primarily by the dollar leg, or in other words by Fed rate expectations and US data. We still expect a turn higher in the pair, but patience is the name of the game for EUR/USD bulls like us, and more downside corrections even after a potential ECB hawkish surprise are a very tangible risk.
