Euro Hurt by Fragmentation Risks After ECB Decision

June 10, 2022

U.S. yields continue to rise; the rise in short-end U.S. yields reflects heightened Fed tightening expectations; May CPI data will be the main event; Canada highlight will be May jobs data
The ECB kept rates steady but flagged a 25 bp hike in July; ECB tightening expectations have picked up; the ECB simply did not seem overly concerned about the risks of rising peripheral yields; Brexit appears to be coming to a head once again; Norway reported May CPI and PPI data; Russia cut rates 150 bp to 9.5% vs. 100 bp expected
Japan officials have renewed their warnings about the weak yen; China reported May CPI, PPI, and new loan data

The dollar continues to gain. DXY is up for the third straight day and has retraced nearly two thirds of its May swoon. It is trading near 103.50, the highest since May 19, and a break above 103.589 would set up a test of the May 13 high near 105. The euro is trading back below $1.05 in the wake of the ECB decision (see below). It had an outside down day yesterday, which points to further losses ahead. The weakening trend in the yen has stalled after USD/JPY made a marginal new high yesterday near 134.55, as rising official concerns has led the pair lower to trade near 133.75. We maintain our long-standing target of the January 2002 high near 135.15 but we need to start talking about the August 1998 high near 147.65. Sterling remains soft below $1.2450 as Brexit risks intensify (see below). We think it’s becoming clear that the May move lower in the dollar was a correction within the longer-term dollar rally and we are heartened by the continuing bounce in June.


U.S. yields continue to rise. The 2-year yield traded at a new cycle high near 2.86% today, up from last month’s low near 2.44% and above the May 4 peak near 2.85%. While the 2-year differential with Germany has fallen to 198 bp, the lowest since the end of February, the gap with Japan has risen to a new cycle high near 292 bp. Today’s price action in the euro (weaker) and yen (stronger) runs counter to what these differentials would suggest. However, when all is said and done, we believe monetary policy divergences remain the dominant driver for FX. With the U.S. economic outlook remains the best relative to its DM peers and so the dollar uptrend remains intact.

The rise in short-end U.S. yields reflects heightened Fed tightening expectations. WIRP suggests 50 bp is fully priced in for June and July. A third 50 bp hike for September is now about 85% priced in vs. 35% at the start of last week. After that, three more 25 bp hikes in November, December, and February are fully priced in. Swaps market is now pricing in a terminal Fed Funds rate of 3.5%, up from 3% at the start of June. This is our best guess too but acknowledge upside risks if inflation remains elevated. Of note, this expected rate peaked near 3.75% on May 5, right after the FOMC meeting.

May CPI data will be the main event. Headline is expected to remain steady at 8.3% y/y, while core is expected at 5.9% vs. 6.2% in April. The Fed will be happy to see the deceleration in average hourly earnings reported last Friday to 5.2% y/y in May vs. 5.5% in April. Prices paid components in both ISM manufacturing and services PMI reports are encouraging, yet we can’t help but fear that we get an upside CPI surprise this Friday. After all, virtually every other country has reported accelerating inflation in May. How can the U.S. buck this trend? Preliminary June University of Michigan consumer sentiment (58.3 expected) and May budget statement (-$170.0 bln expected) will also be reported today. May PPI data will be reported next week.

Canada highlight will be May jobs data. Consensus sees 27.5k jobs created vs. 15.3k in April, with the unemployment rate seen steady at 5.2%. With the economy firm, the Bank of Canada will continue tightening. WIRP suggests 50 bp hikes are fully priced in June, July, and October. Looking ahead, the swaps market is now pricing in 200-225 bp of tightening over the next 12 months that would see the policy rate peak between 3.5-3.75%, up from 3.0% at the start of last week. High oil prices and a hawkish BOC are likely to help CAD continue outperforming. Both AUD and NZD peaked June 3 but NZD has led the move lower. Kiwi has retraced nearly half of its May-June rise and a break below .6355 would set up a test of the May 12 low near .6215. Aussie and Loonie have held up better and have only retraced about a third of the same move.


The European Central Bank kept rates steady but flagged a 25 bp hike in July. It said a 25 bp hike at the July meeting was likely and that it expects to hike again in September followed by “gradual but sustained” hikes beyond that. It said the pace of hikes will depend on the data and the medium-term inflation outlook. Madame Lagarde hinted that a 50 bp move in September was likely if inflation pressures don’t ease. Most importantly, the ECB said it would end QE as of July 1 but will reinvest maturing PEPP bonds at least through end-2024. That means QT is a 2025 story, at least for now, and this strikes us as very dovish. Recently, noted hawk Knot had hinted QT was most likely a late 2023 story but now it seems even more distant than ever. This is a very different path from the Fed, which started hiking rates in March and will start QT next week.

ECB tightening expectations have picked up. WIRP suggests a 25 bp hike July 21 is fully priced in. Then, 50 bp is now nearly priced in for two of the three meetings on September 8, October 27, and December 15 that would take the deposit rate to near 1.0% by year-end. Looking ahead, the swaps market is now pricing in a terminal rate of 2.0% over the next 24 months vs. 1.75% before the meeting. The 2-year U.S.-German yield differential has fallen to 198 bp, the lowest since late February, and yet the euro continues to weaken. We think the rising risks of fragmentation are a major factor behind subsequent euro weakness. Why?

The ECB simply did not seem overly concerned about the risks of rising peripheral yields. The bank said it stands ready to adjust PEPP reinvestment to fight so-called fragmentation but no new emergency bond-buying program was announced or detailed as previously hinted. For now, the ECB simply said that it will adjust PEPP reinvestments which to us seems very limited. If Italian spreads blow out, it will take a lot more than adjusting PEPP reinvestments to address it. Peripheral spreads are moving higher to new cycle highs, as they should after the ECB brought a slingshot to a bazooka fight.

Updated macro forecasts were released. As expected, the ECB forecasts were pretty close to the OECD’s recently updated forecasts for the eurozone, which saw growth in 2022 and 2023 at 2.6% and 1.6% and inflation at 7.0% and 4.6%, respectively.

Brexit appears to be coming to a head once again. Reports suggest the U.K. is making some last-minute tweaks to planned legislation that would allow it to unilaterally rewrite the existing Brexit deal, while the EU prepares to launch legal proceedings as part of its response to the move. The EU has reportedly drawn up a draft statement to follow the expected U.K. move. While the statement reiterates the need to continue negotiations, it also will remind the U.K. that their trade relations are based on following the existing Brexit agreement. The EU for now seems to be taking a more measured approach but has in the past threatened retaliatory tariffs if the U.K. were to unilaterally change the Northern Ireland protocols. Reports suggest the government will move ahead with the planned legislation Monday with the hopes of passage in the House of Commons before Parliament adjourns at the end of July. A potential trade war with its largest trading partner is another reason we remain negative on sterling.

Norway reported May CPI and PPI data. Headline came in at 5.7% y/y vs. 5.6% expected and 5.4% in April, while underlying came in at 3.4% y/y vs. 3.1% expected and 2.6% in April. Headline was the highest since December 1988 and further above the 2% target. PPI inflation eased for the second straight month, offering some hope that CPI pressures will ease in the coming months. At the May 5 meeting, Norges Bank kept rates on hold at 0.75% but reaffirmed its March rate path and signaled a hike at the next meeting June 23. Looking ahead, the swaps market is pricing in 200 bp of total tightening over the next 24 months that would see the policy rate peak near 2.75%, up from 2.5% at the start of this week. This is slightly higher than the bank’s March rate path, which saw the policy rate peak near 2.5% in 2024. The bank’s updated rate path from the upcoming meeting will be closely watched.

Russia central bank cut rates 150 bp to 9.5% vs. 100 bp expected. However, the market was all over the place with several analysts looking for cuts ranging from 200 bp to no cuts all. The bank just cut rates 300 bp at an unscheduled meeting May 26, a mere two weeks ahead of today’s scheduled meeting. Just as it did after the May cut, the bank said that it will consider further cuts at its next meetings. It added that it sees the policy rate averaging 8.5-9.5% in H2. May CPI was reported earlier this week. Headline came in at 17.10% y/y vs. 17.35% expected and 17.83% in April, while core came in at 19.87% y/y vs. 20.0% expected and 20.37% in April. This was the first deceleration in headline since April 2021 but still well above the 4% target. Next policy meeting is July 22 and another cut seems likely then.


Japan officials have renewed their warnings about the weak yen. Policymakers from the Bank of Japan, Ministry of Finance, and the Financial Services Agency reportedly met this week to discuss the situation as USD/JPY made new highs. In a joint statement, the officials expressed concerns about the recent yen weakness and pledged to take action if necessary. According to the Finance Ministry, “Appropriate actions we can take include a wide variety of options.” At this point, we believe verbal intervention is the main tool as reports suggest the BOJ is reluctant to remove accommodation. Without a change in relative monetary policy stances, the weak yen is a natural by-product that FX intervention cannot change. Next week’s BOJ meeting will be key in setting the tone for H2. Elsewhere, Japan reported April PPI. It came in at 9.1% y/y vs. 10.0% expected and a revised 9.8% (was 10.0%) in March. While the moderation is welcome, reports suggest increased government fuel subsidies were a big factor. With the yen still weak and oil prices still high, inflation pressures probably haven’t peaked yet.

China reported May CPI, PPI, and new loan data. CPI is came in steady at 2.1% y/y vs. 2.2% expected, while PPI came in as expected at 6.4% y/y vs. 8.0% in April. Inflation remains the highest since November but well still below the 3% target. Policymakers remain focused on boosting growth and so further monetary easing is likely in the coming weeks. In that regard, new loans came in at CNY1.89 trln vs. CNY1.22 trln expected and CNY645 bln in April, while aggregate financing came in at CNY2.79 trln vs. CNY2.03 trln expected and CNY910 bln in April. This is a welcome rebound as movement restrictions are eased but the renewed COVID outbreaks in Shanghai are a reminder that the recovery won’t be a straight line.

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