This week the euro hit its lowest level in 16 months as traders bet that the European Central Bank will stick to its easing policy, even though widespread inflation is prompting policymakers in the United States and the United Kingdom to raise interest rates.
Traders are increasing their bets that the Federal Reserve and the Bank of England will raise interest rates from historical lows next year, while the European Central Bank is opposing the market’s expectations that it will also raise borrowing costs in 2022.
As a result, the euro fell sharply against the US dollar (the most traded exchange rate), ending the period when the currency was basically free from bond market turmoil.
“The market is preparing for the disagreement between the Federal Reserve and the European Central Bank,” said Athanasios Vamvakidis, head of foreign exchange strategy at Bank of America G10.
The euro fell below $1.13 on Wednesday, the lowest level since July last year, and fell rapidly from nearly $1.16 in the middle of last week.
Although part of the reason for the euro’s recent weakness is the other side of the dollar’s broad rally, the euro has also fallen against other currencies due to the prospect of rising interest rates.
The exchange rate against the British pound reversed its gains in early November and continued to fall to its lowest level since the beginning of the pandemic in February 2020.
Data released on Wednesday showed that Britain’s October inflation rate reached 4.2%, triggering the latest decline in the pound.
Investors were caught off guard by the Bank of England’s unexpected decision to keep interest rates unchanged this month, betting that UK interest rates will rise from the current 0.1% to 0.25% in December to curb the faster-than-expected interest rate price increase.
According to data on Wednesday, consumer prices in the Eurozone are also accelerating, with the annual increase in October reaching a 13-year high of 4.1%. But investor expectations for long-term inflation are even more sluggish-partly because the European Central Bank has been below its 2% inflation target for many years.
Therefore, analysts said that European Central Bank President Christine Lagarde has repeatedly insisted that the bet on a rate hike in the euro zone in 2022 does not meet the central bank’s guidelines, which has begun to be accepted by investors.
After Lagarde told the European Parliament on Monday that the current tightening of monetary policy “does more harm than good” and the conditions for raising interest rates are “extremely unlikely”, the market is now pricing in a rate hike of only one-tenth at the beginning of 2023. Satisfied next year”.
Jane Foley, director of foreign exchange strategy at Rabobank, said: “In the end, the market has realized that central banks will not act together at the same speed.”
ECB staff will release their inflation forecast for 2024 on December 16. Although a weak euro will increase the competitiveness of euro zone exporters, it will push up import prices that have risen rapidly. Isabel Schnabel, a member of the European Central Bank’s executive board, said at an event at Goldman Sachs on Wednesday that a weaker euro will increase the euro zone’s inflation rate by about 0.2 to 0.3 percentage points.
At the same time, the European Central Bank is expected to announce in December that its 185 million euro flagship bond purchase program launched last year in response to the pandemic will end in March 2022. However, investors expect the central bank to simultaneously strengthen its long-term asset purchase program to support economic recovery and limit any selling in the bond market.
The central bank has promised not to raise interest rates until it stops buying major bonds. Currency traders will pay close attention to the December announcement for any signs that the European Central Bank may end asset purchases earlier than market expectations, which may indicate that the rate of interest rate hike is close to expectations and trigger the appreciation of the euro.
Schnabel said at an event on Wednesday that the European Central Bank needs to “closely monitor the upside risks of inflation” and that it should “reserve options so that actions can be taken when needed” in order to “maintain confidence in our determination to act.” Maintain price stability in a symmetrical manner and prevent the two-way inflation expectations from falling out of anchor.”
In recent weeks, expectations of interest rate hikes by the Bank of England and the Reserve Bank of Australia and the Bank of Canada have triggered a round of selling pressure in the global bond market, as investors bet that other central banks will respond similarly to inflationary pressures.
“Perhaps surprisingly, these measures did not happen earlier,” said Foley of Rabobank. “Until a week ago, investors seemed to assume that all these economies were similar. The global market was dragged down by the UK, Canada or Australia. It all seemed a bit behind.”
Leandro Galli, senior portfolio manager of Amundi, said that the European Central Bank may also act cautiously in tightening policies to avoid rising borrowing costs in debt-laden Eurozone member states such as Italy.
“The Fed always tries not to sound too tough, but it is moving in this direction,” Gurry said, betting that the dollar will rise further against the euro. “But it’s harder for the European Central Bank to give up stimulus measures, and they have more time.”