Markets are coalescing around the idea that an ECB rate hike at the next meeting in June is pretty much a done deal at this point. The data justify the move, as inflationary pressures continue to build with no sign that the situation will change in the short term. Several ECB officials have also recently argued that the central bank needs to act proactively to prevent inflation from rising further.
What could change that outlook is if something unexpected happens with inflation. Friday sees the release of flash May CPI readings for the largest economies in Europe, and next week is the reading for the whole of the Eurozone. If it’s hotter than anticipated, that will only firm up bets for the hike next month. But a miss could raise doubts about whether the ECB will hike so soon and might wait another month. Counterintuitively, this would likely weigh on the Euro.
Why a Rate Hike Might Weaken the Euro
All other things being equal, what normally drives fluctuations in forex markets is shifts in yields. Large institutional investors are constantly seeking the best interest rates for their funds and will buy currencies to invest in bonds offering higher returns. The biggest influence on those yields is typically the central bank’s interest rate, since driving yields is the primary purpose of monetary policy. Yields are constantly in flux due to varying expectations around what the central bank will do, among other things.
That’s why, normally, if the central bank is likely to raise rates, the currency tends to strengthen, at least compared to currencies where the central bank will stay pat. But one side effect of raising rates is that the economy slows down. Usually, the central bank raises rates to tame an overheating economy, so this isn’t a major concern. Now, the Eurozone economy is already under pressure, so if the ECB raises rates, the effect will be more dramatic.
Rising Risk Premium Scares Investors
The return on investment for buying a bond has to factor in a couple of things, including inflation during the period and the sovereign risk. Both of these add a premium to the interest rate. Long-term yields in Europe have been rising because investors are less willing to buy those bonds, deeming the risk too high. That means less interest in buying the Euro, putting downward pressure on the shared currency.
For EURUSD in particular, the counterpart, the greenback, has been strengthening as the US is less vulnerable to the situation in the Middle East than Europe is. If the Strait of Hormuz remains closed, the impact on inflation will be greater in Europe, which will keep the Euro under pressure.
What to Look Out For
Friday’s release of flash CPI numbers for the two largest economies in Europe might give markets a sense of direction for the whole number coming out later. The market might react based on whether there is a beat or miss, and if the Eurozone number is in line with the first two, the reaction could be minimal.
First up is French Flash May CPI, which is expected to jump to 2.6% from 2.2% prior. Later in the day, German CPI is anticipated to rise to 3.1% from 2.9% a month earlier. The flash May CPI reading for the whole of the Eurozone comes out on Tuesday and is expected to jump to 3.4% from 3.0% in April.
