Euro: ECB caution with tighter conditions – MUFG

MUFG’s Lee Hardman highlights that the Euro faces downside risks as the ECB meets against a backdrop of sharply higher French bond yields and surging European natural gas prices. MUFG expects the ECB to leave rates on hold today but still projects one more hike in December. Tighter financial conditions and policy uncertainty have weighed on EUR performance recently.

Tighter conditions shape ECB outlook

"The market’s focus will now shift to the ECB’s policy update later today which will attract even more attention than normal given the sharp sell-off in French government bonds which is making the ECB’s job in setting monetary policy even more challenging. We had previously thought that another back-to-back hike was possible encouraged by another upside inflation surprise in September coming in at 3.8%. The price of natural gas in Europe has hit fresh year-to-date highs this month rising further by around 40% and adding to upside inflation risks in the euro area."

"However, the unwanted tightening in financial conditions triggered by the higher government bond yields particularly in France are expected to make the ECB relatively more cautious over the need for further rate hikes and support a decision to leave rates on hold today. The 2-year German government bond yield has already fallen by around 25bps from last month’s highs. The scaling back of ECB rate hike expectations ha been one reason why the euro has underperformed in recently."

"Market participants will be listening closely to updated guidance from the ECB today to better assess how much tighter financial conditions are likely to impact the policy outlook. We still expect another hike by the end of this year in December."

"Other potential policy options include slowing down or pausing QT to help ease upward pressure on government bond yields in the euro area, and/or potentially using the Transmission Protection Instrument (TPI) as a last resort to purchase government bonds if the smooth transmission of monetary policy is disrupted. At the current juncture, we believe it is likely premature for the ECB to send a strong signal that they are preparing to use these policy options."

"Overall, we believe that risks remain tilted to the downside for the euro."

(This article was created with the help of an Artificial Intelligence tool and reviewed by an editor. Know more.)