ECB June Cut Risks Inflation Spike, Euro Dips 0.6%

Key Takeaway

• ECB's June rate cut, despite rising inflation forecasts and stalled wage growth, raises concerns of exacerbating inflationary pressures.
• Political instability in France and Germany weakens the euro by 0.6% against the dollar, adding a political risk premium to eurozone assets.
• Increased market volatility with one-month EUR/USD volatility rising to almost 6%, influenced by US economic data and Fed's rate path.

ECB's June Rate Cut

The European Central Bank's (ECB) decision to cut interest rates in June has sparked significant debate among market analysts and investors. The move, which came ahead of the Federal Reserve's actions, has been viewed by some as a potential policy misstep. The rate cut was implemented despite several indicators suggesting that the eurozone economy was on a path to recovery. Real money growth has been on the rise, and Sweden's economic improvement, as a small and open economy on the eurozone's periphery, pointed to a better growth outcome for the region.

The timing of the rate cut has raised questions, especially as it coincided with the ECB raising its inflation forecasts for 2024 and 2025. Additionally, wage data released shortly after the cut showed that wage growth had stalled, with the growth rate rising back above 5%. This has led to concerns that the rate cut could exacerbate inflationary pressures, particularly with the euro weakening further. Former ECB Governor Jean-Claude Trichet's infamous rate hikes in 2011, which were quickly reversed, have been cited as a cautionary tale, suggesting that the ECB may need to reconsider its current trajectory.

Political Uncertainty

The recent European parliamentary elections have added a layer of political uncertainty to the economic landscape. The ruling parties in France and Germany suffered significant defeats, losing ground to right-of-center parties. In response, French President Emmanuel Macron has called for legislative elections, which has further weakened the euro, causing it to drop another 0.6% against the dollar. This political instability has implications for the eurozone's economic outlook, particularly in terms of inflation.

Austria's central bank governor, Robert Holzmann, expressed concerns about the euro's recent weakness even before the election results. He noted that if the Federal Reserve does not implement the three rate cuts it has outlined for this year, it would impact the exchange rate and, consequently, inflation. With eurozone headline and core inflation hovering closer to 3% than 2%, and the ECB acknowledging that price pressures will remain elevated through this year and next, the case for further rate cuts appears tenuous.

Market Reactions

The market's reaction to the ECB's rate cut and the subsequent political developments has been swift. Traders have added a political risk premium to eurozone assets, leading to increased volatility in the euro's value. One-month volatility has risen to almost 6% from 5%, indicating that currency traders are factoring in the possibility of the EUR/USD declining further. The euro's trajectory will also be influenced by upcoming US inflation data and the Federal Reserve's dot plot, which will provide insights into the Fed's rate path.

The euro has been significantly impacted by the dollar-side of the equation this year, and this trend is expected to continue beyond the French legislative elections. Last week's non-farm payrolls data from the US showed that the economy is still performing well, which could keep the euro under pressure. The political risk premium now attached to the euro has made its prospects more uncertain, with traders and investors closely monitoring developments.

Street Views

• Simon White, Bloomberg (Bearish on ECB's rate cut decision):

  "Christine Lagarde’s rate cut earlier this month look more like increasingly like a policy mistake - one that may even have to be reversed at some point."