EUR: Some hawkish ECB risks after seismic event – ING

Germany’s new government announcement that it will loosen fiscal rules and deploy EUR 900bn in fiscal spending has generated a seismic shift in European markets. Yesterday’s 40bp selloff in bunds was largely matched by other EU sovereigns on the view that deficits will increase, inflation may rise, and growth can improve. Those moves should not be reversed. Beyond that, the risks are probably skewed to the 3% handle in 10-year bunds, ING’s FX analyst Francesco Pesole notes.

An extension to 1.10 in the rally is improbable

“EUR/USD is trading at 1.08 and following a 3%+ rally in the past two sessions. Interestingly, that level is embedding a relatively contained amount of risk premium (i.e. short-term valuation): around 1.2% in our calculations. That is because the key rates-FX transmission channel – the 2-year swap rate differential – has tightened significantly too. That means markets are repricing the ECB curve higher while repricing the Fed curve lower – a dramatic and highly unusual divergence. The EUR:USD two-year swap rate gap is at -145bp (it was -175bp a week ago) and – along with the move in equities and other parts of the yield curve – now returns a short-term fair value for EUR/USD at 1.067. With these considerations in mind, we are reluctant to call for the peak in EUR/USD just yet.”

“The ECB’s widely-expected decision to cut rates by 25bp today should not be influenced by recent market swings. The communication in the statement and during the press conference will however take both fiscal and market developments into greater account. We thought the main question today would be whether the ECB lifts the reference to monetary policy being “restrictive” after taking rates to 2.5% today. We originally thought it wouldn’t, but the notion that fiscal spending is finally coming through could be giving Governing Council hawks some stronger backing.”

“An extension to 1.10 in the rally would be inconsistent with the prospect of US tariffs on the EU and rate differentials, and our model still shows at least a 1-1.5% correction is in store for EUR/USD in the short term. For today and tomorrow, volatility and major risk events argue against actively picking the peak in EUR/USD.”