EUR: Rates up, currency down
We think the European Central Bank (ECB) will be disappointed by the euro's reaction yesterday. We had felt that the hawkishness seen since late April had been an effort to narrow rate differentials with the US and to get EUR/USD higher. The ECB delivered a hawkish update yesterday, eurozone interest rates rose - yet the euro fell. As Francesco Pesole wrote at the time, the weak link was peripheral debt markets being left unprotected without sufficient news on anti-fragmentation support packages. But one also sensed that, as a pro-cyclical currency, the euro may not appreciate rate hikes as growth forecasts are cut. This means we may start to hear more about growth differentials and what they mean for international equity flows. There also seems to be the start of a risk premium being built into the euro now - i.e. EUR/USD is trading some 1.5/2.0% lower than where short-term fair value models suggest. For today, a firm US CPI print and higher short-term US rates could break EUR/USD below 1.0600 in a move to the 1.0500/0520 area. We also favour EUR/CHF lower from these levels.
Elsewhere, yesterday's National Bank of Poland (NBP) press conference brought a surprisingly dovish tone to the market. Governor Adam Glapinski mentioned the impending peak in rate hikes and the indication of rate cuts next year without any sign of an easing in inflationary pressures. One reason behind this tone, in our view, may be the recent weaker PMI and the outlook for a slowdown in GDP. However, even so, in our view, this will not stop inflation from rising further and yesterday's press conference did not convince us that the NBP is changing course.
We continue to believe the terminal rate will reach 8.5%, but it will be a difficult road up for markets. After yesterday's press conference we find Polish rates at the short end of the curve lower despite very strong support from core rates. The differential against the euro has thus moved down by around 20bp. The zloty reacted by weakening, which was corrected towards the end of the press conference. However, in our view, the return of the interest rate differential to mid-May levels has left the zloty unprotected and we could see further PLN weakening above EUR/PLN 4.62 in the coming days. However, in the longer term, we believe that further data from the economy, led by inflation prints, will keep the hiking machine running and nothing will change in the tightening story.
And finally, in continental Europe, we have a Central Bank of Russia (CBR) rate meeting today. Consensus expects a 100bp rate cut to 10%. The rouble has been exceptionally strong given that current account flows now dominate what is left of USD/RUB trading - the current account surplus being worth US$110bn in the January-May period. Not until foreign energy purchases really start to slow (later this year) should we expect much of a decline in the rouble.