The euro struck its lowest level in 16 months this week as traders bet that the European Central Bank would stick to its accommodative policies even though widespread inflation is prompting US and UK policymakers to raise interest rates.
Traders are dialling up their wagers that the Federal Reserve and Bank of England will lift rates from historic lows over the next year at a time when the ECB is pushing back against market expectations that it too will lift borrowing costs in 2022.
The result has been a sharp decline in the euro against the dollar — the most heavily traded exchange rate — ending a period in which currencies had largely shrugged off the turmoil raging in bond markets.
“The market is positioning for a divergence between the Fed and the ECB,” said Athanasios Vamvakidis, head of G10 forex strategy at Bank of America.
The euro sank below $1.13 on Wednesday, its weakest level since July last year and a swift decline from almost $1.16 in the middle of last week.
Although part of the euro’s recent weakness is the flipside of a broad rally for the dollar, the single currency has also lost ground against peers benefiting from the prospect of higher interest rates.
Against the pound, it has reversed a rally in early November and continued falling to its weakest level since the early stages of the pandemic in February 2020.
The latest losses against sterling were triggered by data on Wednesday showing that UK inflation hit 4.2 per cent in October.
Investors, who were blindsided by the BoE’s surprise decision to keep interest rates on hold this month, are betting that UK rates will rise to 0.25 per cent in December, from 0.1 per cent currently, in a bid to tame the faster-than-expected price increases.
Eurozone consumer prices have also accelerated, with annual gains reaching a 13-year high of 4.1 per cent in October, according to Wednesday’s figures. But investors have more subdued expectations for longer-term inflation — in part a legacy of the ECB’s years of undershooting its 2 per cent inflation target.
As a result, ECB president Christine Lagarde’s repeated insistence that wagers on 2022 eurozone rate rises are not in line with the central bank’s guidance is beginning to get through to investors, according to analysts.
Markets are now pricing in just a single tenth of a point rate rise in early 2023 after Lagarde told the European parliament on Monday that tightening monetary policy now would do “more harm than good” and conditions for a rate rise were “very unlikely to be satisfied next year”.
“Finally markets have cottoned on to the fact that central banks won’t all move together at the same pace,” said Jane Foley, Rabobank’s head of FX strategy.
ECB staff are due on December 16 to publish their inflation forecast for 2024. While the weaker euro will boost the competitiveness of exporters in the euro area, it will push up the price of imports that have already been rising rapidly. Isabel Schnabel, an ECB executive board member, told a Goldman Sachs event on Wednesday that the weaker euro would add about 0.2 to 0.3 percentage points to inflation in the bloc.
Meanwhile, the ECB is also expected to announce in December that its flagship €1.85tn bond-buying programme, which it launched last year in response to the pandemic, will come to an end in March 2022. However, investors expect the central bank to step up its longer standing asset purchase programme at the same time to support the economic recovery and limit any sell-off in bond markets.
The central bank has committed not to raise rates before it stops primary bond purchases. Currency traders will be watching December’s announcements closely for any signs that the ECB could end asset purchases earlier than markets anticipate, which could indicate a rate rise is nearer than expected and trigger an appreciation of the euro.
Schnabel told the event on Wednesday that the ECB needed to keep “a watchful eye on the upside risks to inflation”, and said it should “retain optionality to be able to act if needed”, so as to “maintain trust in our determination to defend price stability in a symmetric way and prevent a de-anchoring of inflation expectations in both directions”.
In recent weeks, expectations of interest rate rises from the BoE, along with the Reserve Bank of Australia and the Bank of Canada, have sparked bouts of selling pressures in global bond markets as investors bet that other central banks would respond similarly to inflation pressures.
“Perhaps the surprise is that these moves didn’t happen sooner,” Rabobank’s Foley said. “Up until a week ago investors seemed to be assuming that all these economies were similar. You had global markets getting dragged around by the UK, or Canada, or Australia. It all seemed a little bit backward.”
The ECB is also likely to tread carefully in tightening policy so as not to trigger any rise in borrowing costs for more indebted eurozone members such as Italy, according to Leandro Galli, a senior portfolio manager at Amundi.
“The Fed always tries not to sound too hawkish, but it’s moving in that direction,” said Galli, who is betting on further gains for the dollar against the euro. “But it’s more difficult for the ECB to walk away from its stimulus, and they have more time.”
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