ECB fails to reassure investors and weakens the euro

HYCM

Going into the ECB meeting there was already a high bar set in terms of expectations. Christine Lagarde had signaled a 25 bps hike in July and in September before the meeting. So, when the ECB announced a 25 bps hike in July there was no surprise. The ECB also announced an end to the APP programme as of July 1. This was expected. However, the meeting did hole two more bullish elements that may have been expected to lift the euro.

The euro reaction was surprising on balance

The statement did signal that a potentially larger rate hike may be appropriate in September. This, on balance, was a more hawkish response, especially as the ECB also revised higher their inflation forecasts:

2022 at 6.8% vs 5.1% previous.
2023 at 3.5% vs 2.1% previous.
2024 at 2.1% vs 1.9% previous.

These projections show that inflation is presenting more of a problem to the ECB than they had previously projected. Christine Lagarde stated as much in the opening statement of her press conference that high inflation is a major challenge. Christine Lagarde also linked high inflation forecasts with rate hikes larger than 25 bps when she said ‘if projections put 2024 inflation at 2.1% or higher’ the rate rise will be larger than 25bps.

So why the selling?

The best explanations of the euro selling can be put into three factors: the STIR markets pricing is too aggressive, the prospect of slowing eurozone growth, the risk of fragmentation due to highly indebted countries like Italy and Greece.

The strategist for TD bank told his clients to sell the EURUSD as market pricing would mean one 75 bps rate hike and two 50 bps rate hikes in the remaining four meetings. This is a good point and makes it less likely the ECB can deliver such an aggressive Arte hike.

The risk to eurozone growth is self-evident with the Russian crisis ongoing and energy prices continuing to add strain.

The risk of fragmentation is high as demonstrated by the BTP-Bund spread. The BTP-Bund spread is simply the difference between the yield difference of an Italian 10-year bond and a German bond. The spread is important due to the different risk factors. German bonds are relatively safe compared to the more indebted Italian nation bond. So, the spread acts as a risk premium on the eurozone. In other words, the spread rises higher when euro risk is deemed to be rising too. You can see that when the spread moves higher it often leads to euro weakness.

When this spread rises it shows investors worrying over rising debt risk in the region. Countries like Italy are vulnerable to higher debt costs, so the risk premium is starting to show.

Will this weakness persist?

The outlook for the euro is unclear, but the Fed should offer a fresh direction on Wednesday this week. The key levels are marked below on the EURUSD chart.