Euro Weakens Amid Election Concerns, ECB Rate Cut Doubts

Key Takeaway

• The euro has weakened due to political uncertainty from European parliamentary elections and Macron's snap legislative ballot, raising concerns about prolonged instability.
• Inflation in the euro zone remains high, complicating the ECB's ability to justify further rate cuts amid strong US jobs data and potential Fed policy divergence.
• Market reactions include a decline in French bond futures, a 0.4% drop in Euro Stoxx 50 futures, and a rise in the Bloomberg Dollar Spot Index for three consecutive days.

Euro Weakens Amid Political Uncertainty

The euro has experienced a notable decline following the recent European parliamentary elections, which have introduced significant political uncertainty into the region. French President Emmanuel Macron's decision to call a snap legislative ballot has added to the volatility, with traders now factoring in the potential for prolonged instability. This political backdrop is expected to weigh on the euro for at least the next month, coinciding with the election process.

The election results revealed that both Macron and German Chancellor Olaf Scholz were defeated by far-right parties, exacerbating concerns about the euro's stability. Austria’s central bank governor, Robert Holzmann, had already expressed concerns about the euro's weakness prior to the elections. Holzmann noted, “If the Federal Reserve isn’t able to put through three rate cuts this year as outlined in its dot plot, it would certainly have an impact on the exchange rate, and with it inflation.”

Inflation Concerns Persist

The euro zone is currently grappling with inflationary pressures, with both headline and core inflation rates hovering closer to 3% than the European Central Bank's (ECB) target of 2%. The ECB has acknowledged that price pressures are likely to remain elevated through this year and next, making the case for another interest rate cut increasingly tenuous.

The recent US jobs data has further complicated the outlook for the euro zone. The data showed that payrolls expanded more than even the most optimistic forecasts, suggesting that the Federal Reserve may be less inclined to implement the three rate cuts it had previously outlined for 2024. This development could widen the policy rate differential in favor of dollar-denominated assets, making it more challenging for the ECB to justify further rate cuts.

Market Reactions

The euro's decline has been accompanied by a broader market reaction. French bond futures have slid following Macron's announcement of a snap legislative ballot, while Bund futures have remained relatively stable. Euro Stoxx 50 futures have softened by about 0.4%, whereas S&P futures and Nasdaq contracts have held steady. The Bloomberg Dollar Spot Index has risen for the third consecutive day, with the Treasury 10-year yield adding a basis point to near 4.45%.

Leveraged traders had shifted to net long euro positions ahead of last week's ECB interest rate cut, according to the latest CFTC data. However, the strong US jobs data has pushed the EUR/USD below a momentum support line, adding to the downside bias for the currency pair. As Mark Cranfield from Bloomberg noted, "Macron’s gambit adds additional uncertainty after far-right parties made gains in EU elections, which won’t be well received early in the week when FX markets are less liquid than usual due to various holidays in Asia."

Street Views

• Robert Holzmann, Austria’s central bank governor (Bearish on the euro):

  "If the Federal Reserve isn’t able to put through three rate cuts this year as outlined in its dot plot, it would certainly have an impact on the exchange rate, and with it inflation."