Forex Investment and Currency Trading

Will the next ECB move be a hike? Within five weeks, the market has turned from pricing in two rate cuts by October this year to now expecting a 40% probability of a 25bp rate hike. At least half of this swing in market expectations makes perfect sense.

• In February, markets had been too eager to believe that the ECB would simply follow the Fed and cut rates aggressively in response to a perceived credit crunch. The call for very aggressive ECB cuts ignored the fundamental differences between the two sides of the Atlantic, including the very different divergence of the labour market, with US employment falling while Eurozone employment is still rising.
• To the ECB’s horror, a further surge in oil prices pushed headline inflation to a record 3.6% in March. Even for ECB doves, this overshoot is intolerable. Worse, core inflation is on the rise, reaching 2.0% yoy in March 2008, the highest pace since April 2003, suggesting that inflationary tensions are spreading beyond food and energy costs.
• To make matters worse, the German wage round has gone completely wrong, with wage increases of around 4.5%. Remains of old wage/price indexation mechanisms could also trigger an acceleration in nominal wages in the rest of the Eurozone. In Spain, a majority of workers are covered by “catch up clauses”: if inflation significantly exceeds the forecast used to negotiate wages, the loss in real wages is offset the following year. In France, the minimum wage will be revised up in May, ahead of the normal July assessment, to take into account the acceleration in consumer prices since last summer.
• In addition, most hard economic data are holding up surprisingly well. The Eurozone economy probably managed to expand roughly at its 0.5% qoq trend rate in 1Q.
• Finally, the monetary data show no trace of credit crunch. Mortgage lending is the only segment of credit which is currently decelerating. This reflects to a large extent the exhaustion of solvent demand in some over-stretched markets, such as Ireland, Spain and to a lesser extent France. The correction started well before the financial market turmoil began in the summer of last year. The ECB probably welcomes the adjustment.

So far, for ECB hawks, notably those who look very closely at the German data, the conclusion from all this seems obvious. Economic growth is not (yet) slowing down enough to counteract a serious inflation overshoot. In their view, higher rates are needed to prevent any further increase in wage inflation. If the Euro rises further as a result, so be it. After all, a stronger currency can slightly mitigate the inflationary push from higher oil prices.

Despite some arguments for higher ECB rates, any rate hike debate looks very premature, to say the least, and some of the members of the ECB Governing Council who floated the idea of a rate hike earlier this week were very anxious to backtrack as soon as they realized that their hawkish comments had a sizeable impact on the financial markets.

Christian Noyer’s comments are particularly telling. On Tuesday, the Banque de France Governor, usually considered as a dove, alluded quite directly to the possibility for the ECB to raise its policy rate to curb inflationary pressure. These comments sent the euro/dollar briefly above 1.60. The following day, Noyer backtracked, stating in an interview with the Wall Street Journal that the next movement could go in “both directions” and emphasizing the downside risks to growth which could dampen inflationary pressures. The point was driven home by arch-hawk Stark on Thursday. He stated that the past 200 bps monetary tightening was still working its way through the Eurozone economy and that the current monetary stance was consistent with a flattening in the inflation pace by the end of 2008/early 2009.