Euro Risks Rise, Traders Bet on Fed Cuts Over ECB

Key Takeaway

• Rising political risks in Europe, including Macron's snap election call, are adding uncertainty and impacting the euro and bond markets.
• Traders expect more rate cuts from the Fed than the ECB next year, despite recent ECB hikes and persistent eurozone inflation.
• Historical market responses to political events suggest that while risks can be managed, current conditions complicate ECB's easing bets.

Rising Political Risk in Europe

Interest-rate swap traders are currently anticipating that the Federal Reserve will implement more rate cuts than the European Central Bank (ECB) in the first half of next year. This dovish outlook has not yet been reflected in the dollar's performance. The discrepancy between the two markets can be attributed to rising political risks in Europe. Recent election results and a surprise parliamentary vote in France have introduced significant uncertainty, potentially undermining the euro. The ECB's recent rate hike, which was heavily telegraphed through forward guidance, now appears premature. Simon White has suggested that the ECB may even need to reverse this hike. This scenario could result in relatively higher swap rates without a corresponding strength in the euro.

The unexpected call for an election by French President Emmanuel Macron and the European parliamentary elections' impact on governments in France, Germany, and potentially Ireland, have added to the political risk. The selloff in both bonds and the euro this morning indicates that many market participants were caught off guard by these developments.

Market Vigilantes and Political Risk

Traders are pricing in a broad political risk premium following the European Parliament elections, which saw gains for far-right parties. Historical responses by market vigilantes to political events in Europe suggest that these risks can be managed. For instance, when Giorgia Meloni won the Italian elections in 2022, there were initial concerns about fiscal restraint and right-wing governance. Italian yields rose, and bank stocks fell due to a proposed bank windfall tax. However, Meloni's commitment to EU financial laws and the subsequent watering down of the levy helped stabilize the market.

Similarly, the UK experienced a bond market meltdown following Liz Truss's budget announcement in 2022, which lacked an independent forecast and was introduced during a period of aggressive interest rate hikes by the Bank of England. The BOE had to intervene to prevent a collapse in pension funds. These examples highlight how market vigilantes can influence and contain political risks.

Currently, European central banks are looking to ease monetary policy amid persistent inflation and improving economies. The ECB has already cut interest rates for the first time in this cycle, albeit cautiously, due to ongoing wage and service price pressures. The political landscape remains complex, with Macron's election gambit adding to the unpredictability. Despite the initial market reactions, European credit-default swaps and French OAT spreads have remained relatively contained compared to recent years.

Impact on ECB Easing Bets

The recent European parliamentary elections have further complicated the prospect of another interest rate cut in the region. Macron's call for a snap legislative ballot has added political uncertainty to the euro, which is expected to persist for at least a month. A weaker euro could exacerbate inflation in the eurozone, which is already elevated. Austria's central bank governor, Robert Holzmann, expressed concerns about the euro's weakness even before the election results.

With eurozone inflation hovering closer to 3% and the ECB acknowledging that price pressures will remain high through this year and next, the likelihood of a second rate cut soon was already slim. The recent US jobs data, which showed stronger-than-expected payroll growth, further complicates the ECB's position. If the Federal Reserve is unable to implement the three rate cuts it has outlined for this year, it could impact the exchange rate and inflation. This would make it challenging for the ECB to justify any policy moves that would widen the rate differential in favor of dollar-denominated assets.

Street Views

• Simon White (Bearish on the ECB's rate hike):

  "The ECB’s June rate hike, which it had locked itself into with over-explicit forward guidance, looks premature. It may even need to be taken back."