The EUR/USD price is still hovering around the parity as bulls unsuccessfully try to stage a relief rally. It is likely this pair will continue to trade range-bound as traders prepare for the next European Central Bank (ECB) meeting on September 8.
European bonds tumbled last week on expectations of a major interest rate hike by the ECB as inflation continues to paralyze consumer sentiment. The ECB hiked interest rates by 50 basis points (bps) in July and a similar or even larger hike is expected on September 8 to tame towering consumer prices.
The European economy, which currently stands in a worse position than the US economy, is witnessing a significant weakness in the euro against the US dollar The EUR/USD hit a fresh 20-year low last week as traders continue to bet on another 75-bps rate hike by the Federal Reserve in September.
On the other hand, the ECB raised its benchmark interest rate for the first time in over 10 years in July, raising the deposit rate to 0% from -0.5%, and hinted that more hikes are on the way. Some analysts are skeptical about how significantly the ECB will end up lifting borrowing costs due to the ongoing slowdown in economic activity.
Policymakers will keep a close eye to see whether measured expectations for future price growth surge beyond the 2% inflation target as a notable jump above that level would further shake the public’s confidence in the ECB’s ability to tame soaring prices.
Last month, the European Commission updated its inflation forecasts, expecting it to hit 7.6% in the eurozone and 8.3% in Europe in 2022 as the war in Ukraine continues to add to economic woes in the region.
“Moscow’s actions are disrupting energy and grain supplies, pushing up prices and weakening confidence,” Paolo Gentiloni, Europe’s economics commissioner, said at the time.
Fed Leading the Way
One of the key reasons why ECB is expected to introduce a more aggressive rate increase is that its US counterpart Federal Reserve continues to tighten its monetary policy. The US bond market is split between the 50 bps and 75 bps rate hike that Powell and co could deliver on September 21.
During his speech at the annual Jackson Hole conference, Fed Chairman Jerome Powell reiterated the central bank’s commitment to continue fighting inflation through strong rate hikes.d
The latest consumer price index (CPI) print showed that .US inflation eased to 8.5% in July from 9.1% in June, after the Federal Reserve implemented two consecutive 75 bps interest rate hikes.
Although inflation may have peaked in the US, Treasury Secretary Janet Yellen warned earlier this month that consumer prices remain “unacceptably high” in the country, and bringing them down is Washington’s “top priority.”
Yellen also said that nearly 50% of the increase in prices in the latest CPI print were due to sky-high energy costs. She acknowledged that raising interest rates could cause collateral damage to other economies but the Treasury Secretary voiced her support for the Fed’s efforts to rein in inflation as the labor market remains “very strong.”
Some were hoping that the Fed would slow down the pace of interest rate hikes in September but U.S. central bank leader Jerome Powell lowered those expectations during his Friday speech. Powell highlighted the need to be persistent in monetary policy by taking “forceful and rapid steps to moderate demand.”
Europe Also Loves ‘Forceful’ Actions
European policymakers, including Isabel Schnabel, Francois Villeroy de Galhau and Martins Kazaks, also voiced their support for forceful rate hikes in Europe.
“Both the likelihood and the cost of current high inflation becoming entrenched in expectations are uncomfortably high,” said Schnabel, board member of the ECB.
“In this environment, central banks need to act forcefully.”
Schnable also raised concerns that inflation expectations could surge above the ECB’s medium-term 2% target, with reports also indicating that the public is losing confidence in central banks.
The majority of investors were anticipating a 50 bps increase on September 8, but recent remarks by the European policymakers have increased the chances for a bigger hike.
“Frontloading rate hikes is a reasonable policy choice,” said Kazaks.
“We should be open to discussing both 50 and 75 basis points as possible moves. From the current perspective, it should at least be 50.”
French Central Bank chief Francois Villeroy de Galhau thinks that the neutral level should be attained before the end of 2022, while Kazaks argued neutral level should be reached in Q1 2023. Neutral level refers to a theoretical level where the central bank’s policy is neither accommodative nor restrictive.
Back in May, Christine Lagarde, President of the ECB, said:
“If we see inflation stabilising at 2% over the medium term, a progressive further normalisation of interest rates towards the neutral rate will be appropriate.”
The ECB’s consideration of a more aggressive rate hike comes amid a critical period for the European economy, which faces a slowdown and recession risks. A recession would mostly occur because of raging energy costs, which monetary policy cannot address. But soaring energy prices have increased the pressure on the ECB, which is now contemplating implementing a stronger-than-expected rate hike.
Furthermore, the recession is also not likely to push soaring costs down enough to bring inflation back to the desired target without tighter monetary policy. Growing recession risks make a solid argument to frontload rate increases as it would likely get more difficult to tighten the policy when the slowdown is strongly present.
“With this high inflation, avoiding a recession will be difficult, the risk is substantial and a technical recession is very likely,” Kazaks said.
ECB head economist Philip Lane also weighed in on the matter recently, arguing the ECB should hike interest rates at a steady pace.
Treasury Yields Surging in Anticipation of a Big Rate Hike
As chances for a higher rate hike increased, the 2-year bond yield in Germany also rose to a two-month high of 1.162%. The country’s 10-year yield also rose sharply to 1.548%. The yields then saw a correction as gas prices plummeted after Germany’s economy minister said he expects prices to decline as the country is anticipated to hit its 85% October 1 storage target early next month.
Italy’s 10-year yields surged 17 bps to 3.873%, their highest mark since mid-June.
Danske Bank analyst Piet Christiansen said the European central bank clearly looks determined to frontload the rate hikes “and this will linger on ahead of the September meeting.”
UBS strategist Rohan Khanna said the ECB will be more likely to activate its Transmission Protection Instrument if it frontloads the hikes. The instrument allows ECB to purchase bonds from countries whose borrowing costs are increasing relative to Germany.
Summary
The ECB will attract a lot of investors’ attention in early September amid rumors the central bank is considering raising its benchmark interest rate by 75-bps as it races to cool down inflation. In the meantime, the EUR/USD has printed new 20-year lows on bets the ECB’s US counterpart will deliver the third consecutive 75-bps rate hike.
