Pound / Euro: There's Already a Lot of ECB in the Price

• EUR's post-ECB rally eases
• Lagarde pushes back against expectations
• Market expectations becoming elevated: analysts
• But Citi are bullish EUR from here

Above: Christine Lagarde. Image by Dominique HOMMEL. © European Union - Source: EP.

The Euro has stabilised after European Central Bank President Christine Lagarde attempted to cool building market expectations for higher Eurozone interest rates in an appearance before EU lawmakers.

Appearing before a hearing of the European Parliament Lagarde said there was "no need to rush" on making conclusions as to the ECB's intentions to tighten monetary policy.

The comments could limit rising expectations for Eurozone rate hikes and come just days after Lagarde effectively green-lit expectations for a first hike to come in 2022 by dropping previous guidance that explicitly stated no such move would occur this year.

"Lagarde tried to put the hawkish genie back into the bottle at EP," says Carsten Brzeski, Global Head of Macro at ING.

At the ECB's February meeting Lagarde said members of the Governing Council were now unanimous in their concern inflation was becoming elevated and some action would therefore be required on interest rates to ensure prices stabilised back at 2.0%.

But Lagarde said on Monday there was "a real chance inflation will stabilise" at the 2% target, which she said would lead to a "normalisation of our monetary policy".

"Don’t expect the ECB to rush to the exit," says Brzeski. "Last week’s ECB has simply marked a turning point. A turning point, opening the door to a faster reduction of asset purchases and the door to a rate hike this year."

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Lagarde said the ECB intends to "take the necessary decision" in March, that would include "gradually reducing" its asset purchase programme; a prerequisite to rate hikes.

The yield paid on Eurozone bonds surged last week, raising the cost of borrowing across the area, after the ECB signalled a shift in thinking that aligned it more closely with other major central banks that are closing the door on easy policy in the face of surging inflation.

The rising bond yields pulled Euro exchange rates higher alongside.

The Pound to Euro exchange rate rose to a two-year high above 1.20 but then promptly declined in the wake of the ECB event, taking it the month's low at 1.1792.

The Euro to Dollar exchange rate was as low as 1.1221 in early February but has since recovered to above 1.14.

Looking ahead, for Euro exchange rates much now depends on whether or not the market has become too aggressive about the prospects for rate hikes and whether pricing falls back.

The simple rule of thumb is that were the market to price in more aggressive rate hikes, then the Euro would climb further.

Above: daily chart showing GBP/EUR rise as Bank of England rate hike expectations rose. Will rising expectations for an ECB rate hike stop the rally?

Secure a retail exchange rate that is between 3-5% stronger than offered by leading banks, learn more.

But if some of the expectations that have built up since last Thursday fade then the single currency can give back some gains.

Financial market expectations for ECB rate hikes have ramped up noticeably over the past month with the front-end of the euro curve now pricing in 50 basis for 2022, or two increases, says Kenneth Broux, a strategist at Société Générale.

Ahead of last Thursday's policy report the curve was pricing in a single 25 basis point hike.

Chiara Silvestre, Economist at UniCredit, says euro money market forwards now price in an increase in rates of about 110bp by the end of 2023, 100bp of which fall by September 2023.

The terminal rate implied by the market stands at 0.60% from 2024, thereby pricing in a deposit rate not too much lower than the peak seen in the 2011 mini-cycle.

"It is fair to say that a lot is priced in with respect to monetary policy tightening, so additional pressure on EGB yields coming from this factor should now be limited," says Silvestre.

But, there is an additional complication: all the above hike expectations assume the central bank will hike by 25 basis points, as is typical for central banks.

But the ECB in fact could hike by smaller increments.

ECB Governing Council member Klaas Knot said in a weekend interview he expects a rate rise by December 2022 and that "normally we would raise rates by a quarter percentage point, I have no reason to expect we would take a different step."

"The market is fully priced for the first 25 hike only by September. But the ECB cut in 10bp steps once rates went below zero," says Daragh Maher, Head of U.S. FX Strategy at HSBC. "It is possible that sub-zero hikes would be in similar increments."

If there is only one hike in 2022 - and it is of 10 basis points - market hiking expectations would be disappointed.

This would potentially weigh against Euro exchange rates.

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"All in all, expect further attempts by ECB members in the coming weeks to steer and influence the policy debate in either direction. This will come with volatility in financial markets," says Brzeski.

"We think that market speculation about the ECB’s tapering and rate lift-off is currently as exaggerated as it was underappreciated just one week ago. Over the last 20 years, the ECB has hardly been in a rush to drastically change its stance," he adds.

John Nihill, an analyst at Citi, notes the market is now "very long" on the Euro since the ECB, and that the crowded position helped trigger a pull-back in the single currency at the start of the new week.

UniCredit's Silvestre says the "bear flattening" seen on the German Bund curve indicates that investors expect a
steep but brief rate hike cycle.

"This is also a signal that markets are seeing the central bank action as successful in keeping inflation expectations under control in the medium term," says the analyst.

Her FX strategist colleague at UniCredit, Roberto Mialich, says the effective margin of tightening the ECB can reasonably deliver over the coming months remains less intense than elsewhere, "therefore it cannot offer a significant boost to the currency but rather more seesawing in the near term."

But strategists at Citi are of the view the Euro can go higher over coming months, making the case for Euro upside in a post-ECB note.

They describe the ECB's newfound hawkish signal as an "historic pivot" and as a result they "turn selectively bullish on EUR".

They cite three main drivers at play:

(i) a change in sentiment for EUR-funded trades;
(ii) prospects for world equities to outperform their US counterparts; and
(iii) a more optimistic euro area growth outlook as the reopening of regional economies gets underway.