Euro hit by bets ECB monetary policy will diverge from major peers

The euro struck its lowest level in 16 months this week as traders bet that the European Central Bank (ECB) will stick to its accommodative policies even though widespread inflation is prompting US and UK policymakers to raise interest rates.

Traders are dialling up their wagers that the Federal Reserve and Bank of England (BoE) will lift rates from historic lows over the next year at a time when the ECB is pushing back against market expectations that it too will lift borrowing costs in 2022.

The result has been a sharp decline in the euro against the dollar – the most heavily traded exchange rate – ending a period in which currencies had largely shrugged off the turmoil raging in bond markets.

"The market is positioning for a divergence between the Fed and the ECB," said Athanasios Vamvakidis, head of G10 forex strategy at Bank of America.

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The euro sank below $1.13 on Wednesday, its weakest level since July last year and a swift decline from nearly $1.16 in the middle of last week.

Although part of the euro’s recent weakness is the flipside of a broad rally for the dollar, the single currency has also lost ground against peers benefiting from the prospect of higher interest rates.

Against sterling, it has reversed a rally in early November and continued falling to its weakest level since the early stages of the Covid pandemic in February 2020.

The latest losses against sterling were triggered by data on Wednesday showing that UK inflation hit 4.2 per cent in October.

Investors, who were blindsided by the Bank of England’s surprise decision to keep interest rates on hold this month, are now betting that UK rates will rise to 0.25 per cent in December, from 0.1 per cent currently, in a bid to tame the faster-than-expected price rises.

Inflation

Euro zone consumer prices have also accelerated, with annual gains reaching 4.1 per cent in October, according to Wednesday’s figures, but investors have more subdued expectations for longer-term inflation – in part a legacy of the ECB’s years of undershooting its 2 per cent inflation target.

As a result, ECB chief Christine Lagarde’s repeated insistence that wagers on 2022 ECB rate hikes are not in line with the central bank’s guidance is beginning to get through to investors, according to analysts.

Markets are now pricing in just a single tenth of a point rate rise next year after Ms Lagarde told the European Parliament on Monday that tightening monetary policy now would do "more harm than good".

"Finally markets have cottoned on to the fact that central banks won't all move together at the same pace," said Jane Foley, Rabobank's head of FX strategy.

In recent weeks, expectations of rate rises from the BoE, along with the Reserve Bank of Australia and the Bank of Canada, have sparked bouts of selling pressures in global bond markets as investors bet that other central banks would respond similarly to inflation pressures.

“Perhaps the surprise is that these moves didn’t happen sooner,” Ms Foley said. “Up until a week ago investors seemed to be assuming that all these economies were similar. You had global markets getting dragged around by the UK, or Canada, or Australia. It all seemed a little bit backward.”

Indebted

The ECB is also likely to tread carefully in tightening policy so as not to trigger any rise in borrowing costs for more indebted euro zone members such as Italy, according to Leandro Galli, a senior portfolio manager at Amundi.

“The Fed always tries not to sound too hawkish, but it’s moving in that direction,” said Mr Galli, who is betting on further gains for the dollar against the euro. “But it’s more difficult for the ECB to walk away from its stimulus, and they have more time.” – Copyright The Financial Times Limited 2021