Euro Weakens as ECB Cuts Rates, Political Risks Rise

Key Takeaway

• European markets face heightened political risk after far-right gains in EU elections, impacting euro and bond yields.
• ECB's recent rate cut amid persistent inflation contrasts with Fed's potential rate hikes, affecting eurozone monetary policy.
• French President Macron's call for a snap legislative ballot adds to uncertainty, weakening the euro and complicating ECB rate decisions.

Political Risk Premium

Traders are currently pricing in a broad political risk premium following the European Parliament's election results, which showed significant gains for far-right parties. This development has raised concerns about the potential impact on European markets. Historical examples provide some context for understanding how market vigilantes have responded to political shifts in Europe.

For instance, when Giorgia Meloni won the Italian elections in 2022, there were initial concerns about fiscal restraint and right-wing governance in one of the world's most active debt markets. Italian yields surged not only due to these political risks but also because of the European Central Bank (ECB) tightening its policy. Italian bank stocks also took a hit as Meloni proposed a bank windfall tax. However, fears subsided when Meloni committed to respecting EU financial laws, and the government later watered down the levy after markets reacted negatively.

Similarly, the UK experienced a bond market meltdown following Liz Truss's budget announcement in 2022, which aimed to grow the economy amid aggressive interest rate hikes by the Bank of England (BOE). The plan, introduced without an independent forecast from the Office for Budget Responsibility, led to a crisis that forced the BOE to intervene to prevent pension fund collapses.

Central Bank Policies

European central banks are now looking to ease monetary policy in response to persistent inflation and improving economic conditions. The ECB recently cut interest rates for the first time in this cycle, albeit in a hawkish manner, as services and wage price pressures continue. The ECB is expected to keep rates on hold this summer, with a 50% chance of a rate cut in September.

Despite the political uncertainties, the euro and European stocks fell, and bond yields rose following the election results. However, European credit-default swaps and French OAT spreads, although widening, remain relatively contained compared to recent years.

Robert Holzmann, Austria’s central bank governor, expressed concerns about the euro's recent weakness, stating, "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."

Market Reactions

The outcome of the European parliamentary elections has made the prospect of another interest rate cut in the region even more distant. French President Emmanuel Macron's call for a snap legislative ballot has added to the political uncertainty surrounding the euro, which is expected to persist for at least a month. A weaker euro could exacerbate inflation in the eurozone, which is already hovering closer to 3% than the ECB's target of 2%.

The recent strong US jobs data has further complicated the situation for eurozone traders. With payrolls expanding more than expected, the Federal Reserve may find it challenging to implement the three rate cuts it had planned for 2024. This could widen the policy rate differential in favor of dollar-denominated assets, making it less likely for the ECB to pursue further rate cuts.

Mark Cranfield from Bloomberg noted, "The euro is set for near-term underperformance after French President Emmanuel Macron surprised traders by calling a snap parliamentary vote, with a softer shared currency likely to be the safety valve."