Euro soars as ECB signals it will hike rates soon

Tom Tong07/Mar/2011Currency Updates

The ECB upended financial markets last Thursday, surprising investors with an extremely hawkish statement, followed by a press conference in which Trichet all but confirmed that an interest rate hike is coming as early as next meeting. Markets had spent the week focused mostly on the events in the Middle East and North Africa, with the oil price driving other markets and a negative correlation emerging for the first time in a long time between commodity prices (in particular, oil) and other risk assets, particularly stocks. However, the resilience of risk assets in the face of shocks (from oil and European rates, so far) is remarkable.

The dollar appeared to confirm the regime shift we commented on last week, failing to rally on geopolitical tensions and sliding further in response to the ECB bomb on Thursday.

EUR

The common currency was the star of the week. After spending the first half of the week trading erratically higher, it received a major boost on Thursday when the ECB used the unmistakable code words “strong vigilance [on inflation]” and Trichet confirmed in the press conference that monetary policy was no longer “appropriate”, all but pencilling in a hike in the next meeting in April. While he did mention that this hike will not necessarily be the beginning of a full-fledged hiking cycle, the extremely hawkish tone sent short term interest rates in Europe and the currency sharply higher. Somewhat surprisingly, peripheral spreads were more or less stable on the news, although the absolute level of rates rose in tandem with the rest of the curve.

This significant change in the ECB outlook makes it all the more necessary that the European Council deliver on market expectations of a solid new package for dealing with peripheral solvency concerns by their self-imposed late March deadline. We believe that failure to upsize the rescue facility beyond 500 billion euros and lower rates charged to recued countries to sustainable levels will result in a reigniting of the peripheral sovereign crisis, now made worse by the sharply higher level of overall rates. Therefore, we maintain a cautious stand on the euro.

GBP

A spate of softer-than-expected data releases in the UK (business sentiment indices and housing prices, primarily) was overshadowed by the ECB hawkishness. The resultant sell off in the Euribor curve carried over somewhat to the short sterling curve on the theory that the Bank of England will be under additional pressure to hike given the hawkishness across the Channel. As a result, sterling ignored the softer data and once again behaved as a low-beta version of the euro, rising 1% against the dollar but losing above 0.8% against the common currency.

USD

The main event of the week was the February payroll report released on Friday. However, it was overshadowed by the dramatic headlines coming out of Libya and the ECB shocker on Thursday. The report itself was rather positive, showing a healthy pace of job creation and continued reduction in the unemployment rate, albeit from still very high levels. The positive tone in US macroeconomic releases did little to arrest the slide in the greenback, though. As we have pointed out, this breakdown in the correlation between flight-to-quality trades and upward pressure on the dollar is the most noteworthy development in FX markets for quite a while. All in all, however, the extreme short dollar positioning among traders should make it difficult for the dollar to sell off any further in the near term.

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Written by Tom Tong

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