EUR boosted by ECB: Hawks remain in charge after 0.5% rate hike
Updated
The euro was lifted by a hawkish European Central Bank on Thursday after the main interest rate was raised by 50 basis points to 2.5%.
Furthermore, the accompanying statement left no doubt that further hikes would be delivered in 2023, based on a "significant upward revision" to the ECB's inflation forecasts.
The statement read: "Interest rates will still have to rise significantly at a steady pace to reach levels that are sufficiently restrictive to ensure a timely return of inflation to the 2% medium-term target."
The ECB also announced the principles for the quantitative tightening (QT) programme, which will start from March 2023 and will reduce the asset purchase programme (APP) portfolio at a monthly average pace of €15 billion until the end of the second quarter of 2023, with the subsequent rate determined over time.
The euro soared to 1.07 levels against the dollar during President Lagarde's press conference before retracing down to 1.065 as of this writing. The single currency held up its gains nicely in other FX crosses against the British pound (EUR/GBP) and the Japanese yen (EUR/JPY).
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Euro rallied during the ECB meeting
EUR/USD, EUR/GBP, EUR/CHF, EUR/JPY reactions post ECB meeting – Chart: Capital.com, Source: TradingviewECB is now the most hawkish G10 central bank
During the press conference, President Lagarde sounded extremely hawkish, stating that it is "obvious" that the ECB will continue to boost rates consistently by 50 basis points for some time.
She stated that there is still more ground to cover, "more than the Fed", and that the ECB will operate with "perseverance" to achieve the 2% inflation target.
Lagarde also strongly pushed back against market expectations which prior to the meeting were positioned for a 3% peak in eurozone interest rates next year. "According to the latest information about inflation, the next meeting will be 50 bps, possibly the next one as well, and possibly the one after that", she said.
She also signaled that once the peak is reached, "it won't be enough to hit and then withdraw" and high-interest rates will stay for a longer time.
Euro area sovereign yields spike as the ECB announces QT
As the ECB announced the start of the Quantitative Tightening programme in March 2023, eurozone sovereign bonds sold off sharply, with yields spiking and spreads versus Bunds widening.
Italian 10-year BTP yields skyrocketed 25 basis points to 4.13%, Spain 10-year Bonos yields were up 17bps to 3.16%, France 10-year OAT yields also spiked 17bps to 2.59%, while Bund yields rose 15bps to 2.09%.
With the QT in place, the ECB will not reinvest all of the principal payments from maturing assets in the APP programme. Its asset holdings in the APP will decline at a pace of € 15 billion per month, until the second quarter of 2023, and its subsequent pace will be set over time.
Euro area sovereign bond yields reactions to the ECB meeting – Chart: Capital.com, Source: TradingviewEuro fundamental outlook: Downside capped against the USD, more upside room versus the JPY
The ECB is playing the long game and will continue to increase aggressively by 50 basis points in the coming meetings, requiring the market to significantly reprice higher its dovish expectations for future eurozone interest rates.
This will likely result in higher yields across the sovereign bond market in the eurozone, which would likely narrow the negative spread between German Bund yields and US Treasury yields.
This may be also a positive factor for the euro, or at least one that mitigates its drop against the dollar, given that the Federal Reserve likewise sounded aggressive and signalled that interest rates will continue to rise next year.
According to the chart below, the Germany-US 2-year yield differential has returned to play an important role in explaining the EUR/USD pair's moves.
Compared to where the 2-year yield gap between Germany and the US is right now, the euro-dollar exchange rate looks to be trading at a discount. EUR/USD rate was at about 1.09 when the yield differential between Germany and the US was at this level in the past.
I think there might still be some marginal space for additional gains in EUR/USD if the ECB continues to raise interest rates aggressively, while there may be greater upside room for the euro versus low-yielding currencies such as the Japanese yen, given the BoJ's inaction.
EUR/USD vs 2-year Germany/US yield spread
EUR/USD vs 2-year yields differential between Germany and US – Chart: Capital.com, Source: TradingviewIf the 2-year yield spread between German and Japanese bonds widens to 2.5%, EUR/JPY has room to hit 150 levels. Also in this case, the euro is slightly lagging behind with respect to levels that the yield differential would suggest.
EUR/JPY & 2-year Germany vs Japan yield spread
EUR/JPY vs 2-year yield differential between Germany and Japan