ECB Signals And Market Response
We see a growing chorus of ECB officials signaling a rate hike this month to protect their credibility. Key figures are openly discussing the need to act pre-emptively against inflation spilling over from energy to the broader economy. Yet, short-term interest rate markets seem too complacent about the potential for a more aggressive hiking cycle. This view is reinforced by last week’s flash CPI data for the Eurozone, which showed inflation unexpectedly accelerating to 3.1% in May. More importantly, core inflation, which strips out volatile energy prices, also ticked up to 2.9%, suggesting these price pressures are becoming embedded. This is exactly the kind of “second-round effect” that officials have been warning about. The memory of being late to hike in 2022, when inflation surged past 8%, is clearly influencing the current debate. Policymakers are determined not to repeat that mistake, which is why even traditional doves are now arguing for a “credibility hike.” We believe this makes a move at the June 11th meeting almost a certainty, regardless of any short-term weakness in activity data.Strategy Implications And Euro Outlook
Consequently, we see value in positioning for a steeper front-end of the Euro yield curve. Futures contracts, such as those on the 3-month EURIBOR, appear to be underpricing the risk of at least two hikes by the end of the third quarter. Options strategies that benefit from rising short-term rates, or higher volatility in rates, should be considered. This policy divergence should also lend support to the Euro, especially against currencies where the central bank is perceived to be pausing. As of today, options markets are showing relatively low implied volatility for EUR/USD, suggesting that long-Euro positions can be established with attractive risk-reward profiles. We anticipate a move back towards the 1.10 level if the ECB delivers a hawkish message this month.Start trading now — click here to create your real VT Markets account.
