The euro climbed further against currencies including the dollar (EUR/USD) and pound (EUR/GBP) on Tuesday morning, after the head of the European Central Bank (ECB) said the era of negative interest rates in the eurozone would end in the coming months.
In a blog, Christine Lagarde said a series of shocks – including the Russia-Ukraine war, lockdown reopenings and the failure of OPEC+ to meet production targets – had pushed inflation to record highs, signalling the need for a u-turn on her previous opposition to rate hikes.
Net purchases under the ECB’s asset purchase programme are set to end very early in the third quarter, allowing for “rate lift-off” at the its July meeting, Lagarde said.
“Based on the current outlook, we are likely to be in a position to exit negative interest rates by the end of the third quarter,” she wrote.
Extending a rise on Monday, the euro was up 0.13% against the greenback to 1.0707 and up 0.85% to 0.8561 against sterling at 12:00 GMT on Tuesday.
EUR/USD exchange rate chart
No rush
The ECB’s deposit rate is -0.5%, and has been below zero since 2014 as it tried to combat low inflation. Lagarde’s comments could mean a move to 0 or into positive rates.
In her blog, Lagarde said that investors have been progressively updating their expectations of the ECB’s policy intentions, causing a revision of interest rate expectations and an upward shift in real rates at the longer end of the yield curve.
Markets are now pricing in four quarter-point rate rises through the rest of the year, one at each meeting.
However, in an interview with Bloomberg, Lagarde said “gradualism is the way to go as long as inflation expectations are well anchored.” She said inflation was currently being fuelled by supply constraints rather than a surge in demand, so “we don’t have to rush, we don’t have to panic.”
She added that her comments should not be translated into a definitive percentage point, and that the ECB would continue to be attentive to new economic data.
Growth factor
In her blog, Lagarde also raised the need to consider the eurozone’s growth outlook, and noted consumption and investment remain below their pre-crisis levels, and even further below their pre-crisis trends, a factor being compounded by negative supply shocks.
But while growth is a concern, Lagarde told Bloomberg a eurozone recession was not its baseline assumption.
The S&P flash eurozone Purchasing Managers’ Index, published today, suggested economic growth in the bloc was holding up despite inflation and supply issues, with the service sector rebounding strongly, but manufacturing growth slowing.
EUR/GBP rate
Bargain hunt
Jane Foley, head of FX Strategy at Rabobank, told Capital.com that while news that the ECB may be prepared to hike rates as soon as July, Lagarde was clearly unwilling to be drawn on the possibility of a 50 basis points move.
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“While the outlook for rates may have been a trigger for the better tone in the EUR, there are signs of technical trading also. The fact that EUR/USD failed to break below 1.035 earlier this month has likely been a trigger for some bargain hunting.”
As the dollar has strengthened in recent months amid volatile global markets and a hawkish stance from the US Federal Reserve, a declining euro has led analysts to raise the possibility of it hitting ‘dollar parity’.
Euro woes
Officials including French central bank governor, Villeroy de Galhau, and ECB executive board member, Isabel Schnabel, have recently raised concerns about the weakness of the euro, which has depreciated more than 13% against the dollar over the last year.
Analysts at ING said the weaker currency was a headache since both energy and commodity prices – key drivers of inflation – are invoiced in US dollars.
“The ECB recognises that the euro’s extraordinary weakness creates a serious inflationary danger, which, in the middle of Europe’s energy crisis, threatens becoming a major wildfire,” said Piero Cingari, analyst at Capital.com.
“The ECB’s credibility is at stake here, and the only way to avert a crisis of trust in the single currency is for Frankfurt to hike interest rates steadily in the coming quarters. By the end of the summer, we could see positive interest rates in the eurozone, which would be a paradigm shift after decades of negative rates.
“Expectations of higher interest rates in the Euro Area may thus dampen the free fall of the euro versus the dollar as the policy divergence between the Fed and the ECB begins to narrow.”
Meanwhile Yohay Elam, analyst at FXStreet, told Capital.com: “Lagarde noted that she is attentive to the level of the euro – and the recent devaluation undoubtedly contributed to her calculations. A weaker euro pushes inflation higher and her comments counter that.”
“I think the ECB has a narrow window of only a handful of months to raise rates before economic weakness forces it to an abrupt halt. At that point, the euro could reverse its gains,” Elam added.
