The consensus among economists is that the ECB will hike by another 50bps. But there is this unusual situation where the ECB has its rate decision right after the Fed (and members will be meeting at the same time as the BOE). As the US is the largest trade partner, it’s understandable that the ECB will consider what the Fed does when it decides policy.
The main driver of the EURUSD, naturally, is the interest rate spread between the Euro and the Dollar. But not just the interest rate, the inflation rate has to be taken into account, because it’s an important factor for investors. Particularly now with interest rates so high, and varied across geographies.
What’s the real return on investment?
Currently, the ECB’s interest rate is 2.0% and the Fed is double that at 4.0%. But we have to factor in inflation. Here we don’t use core inflation, even though that’s the preferred measure by central banks. Investors care how much their money is actually worth, taking into account as many factors as possible.
November inflation in the Eurozone was reported at 10% (preliminary, but the final usually doesn’t vary much); while in the US it was at 7.1%. So, there is a 2.0% (or 200 basis point) spread in favor of the dollar, given the interest rates. But, on top of that, there is a 2.8% difference in inflation. Meaning that holding Euro debt will lead you to a bigger loss than holding dollar debt. Hence, the strong preference for the dollar.
It’s about the future, too
But, investors aren’t investing in the past; they want to know where things will be in the future. If the central bank is aggressively raising rates, then it means they will bring inflation down. That’s what the Fed has been doing lately, and inflation in the US is trending downward. But the ECB has been much slower to raise rates, so inflation has been trending higher, with only November’s figure (as yet unconfirmed) turning the trend.
The thing is, since the Fed has already pushed rates higher, there is less hiking in the future for the dollar. While the ECB still has over 200bps to catch up, meaning they could keep hiking for longer. Particularly if we consider that inflation is higher now, than the peak for the cycle in the US. Meaning that the Euro could be undervalued for now, and if the Fed signals that it will start slowing rates, while the ECB signals that it will keep aggressively tightening, the EURUSD could catch some tailwinds.
There are other factors
Europe has managed to reduce energy consumption by around 20%. Energy being the largest driver of inflation in the shared economy. So far, industrial production hasn’t faltered, leaving the Euro Area with a still positive GDP, and expectations that Q4 will also show growth. This gives the ECB more room to keep hiking, unlike other central banks.
That’s why there is a chance of a surprise 75bps hike from the ECB, which could narrow the interest rate gap and give the EURUSD a push. On the other hand, if the ECB matches the Fed’s 50bps, there is also a good change that Lagarde will be quite hawkish, which could also support the Euro. Dovish commentary from the ECB at this point would be quite a surprise for the markets.