More constructive outlook on the euro, but challenges remain
With the ECB’s hawkish shift, we recently turned more constructive on our outlook about the European common currency. Nonetheless the renewed sell-off in bond and equity markets has virtually erased the euro’s previous gains versus the US dollar within a matter of days.
The pronounced monetary policy divergence between the ECB and the Fed has long weighed on the euro. Yet we think that the euro should be close to its trough. The persistence of unusually high inflation readings for the euro area has increased the pressure on the ECB to act much more decisively than it has previously envisaged. By announcing a 25bp policy rate hike for July and indicating another 50bp hike for September as part of the monetary policy meeting held in the week of 6 June, the ECB is now clearly perceived as committed to fighting against inflation as it stresses that inflation will remain undesirably elevated for some time. We now project the ECB to raise interest rates at each of its coming six meetings. On the back of the ECB’s hawkish shift, the EUR-USD yield differential has turned in favour of the euro, which substantiates our constructive view on the currency as explained below.
First, the ECB’s special conditions for its long-term refinancing operation (TLTRO III) are expiring. As lenders from the European periphery substantially benefited from this situation, it contributed to the recent widening of the spread. After the ad hoc meeting held in the week of 13 Jun, the ECB Governing Council tasked its staff to explore the set-up of a possible new anti-fragmentation instrument. Preventing fragmentation risks is crucial for an orderly transmission of the ECB’s monetary policies and hence equally important for the euro’s exchange rate versus the US dollar. Consequently, markets will continue to closely monitor developments on this front.
Second, we emphasize that the euro remains exposed to the global cycle, which presents the US dollar a relative edge. So far, PMIs have continued to print at relatively robust levels. Going forward, global macro momentum is poised to drop further. Pent-up demand should continue to diminish while cost-of-living increases will likely squeeze consumption. Moreover, China should also reinforce the global slowdown given the country’s continued strict adherence to its zero-COVID approach. The delayed reopenings in Beijing and Shanghai continue to depress economic activity, which will remain a challenge for supply chains in the manufacturing-intensive economies of the euro area.
Lastly, we stress that with the Russian army having gained more Ukrainian territory as of late, the conflict between Russia and the West is likely to drag on for a prolonged period. As for the euro area, this likely protracted conflict means that a broader cut-off from Russian gas in the fourth quarter remains a distinct possibility. As it would likely push the euro area into recession, a cut-off from Russian gas remains another – perhaps underestimated – downside risk for the European currency.
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