How Will ECB Rate Hikes Affect the Euro?

At its June meeting, the European Central Bank (ECB) confirmed plans to raise interest rates in July and September, heralding the end of 11 years of ultra-accommodative monetary policy.

So, what could this mean for the Euro (EUR)?

Euro (EUR) Exchange Rates May Rise

Since the fourth quarter of 2021, EUR has declined against both the Pound (GBP) and the US Dollar (USD) as central bank policy divergence weighed heavily on the single currency.

As markets responded to Bank of England (BoE) rate rises, the Pound Euro (GBP/EUR) exchange rate rose from €1.17 to €1.215 – its highest level since the June 2016 Brexit referendum.

Meanwhile, the Euro US Dollar (EUR/USD) exchange rate fell below $1.04, its lowest level in nearly two decades, as the Federal Reserve grew more hawkish and the ECB held back.

Now, however, the Euro is staging a comeback. While the ECB prepares to raise rates, both the BoE and the Fed look set to pause tightening plans. As the gap between policy approaches narrows, EUR/GBP and EUR/USD should rise further. The single currency’s low point may have passed.

All other considerations aside, the Euro should strengthen against is key rivals through the third quarter of this year and perhaps beyond. However…

Huge Uncertainty Remains

There are plenty of factors that could affect the Euro, and the uncertainty that has characterised markets in recent years looks set to continue. Let’s examine those ‘other considerations’ we so blithely brushed to one side in the previous paragraph.

Smaller Rate Rises

At June’s meeting, the ECB hinted at a 50-bps rate rise in September. Now markets are starting to price it in. There is a chance that the ECB could disappoint with a smaller hike or even a pause. If economic data starts to show a sharper-than-expected slowdown in growth, the ECB might revert to its dovish ways.

Recession in the Eurozone

Another key factor is the strength of the Euro-area economy. While there has been some promising data recently, serious concerns remain.

Runaway inflation, fuelled by surging energy prices, is hurting businesses and crippling consumer spending. At the same time, growth is slowing. At the June meeting, the ECB revised its growth forecasts down from 3.7% to 2.8% in 2022 and from 2.8% to 2.1% in 2023.

If energy prices continue to rise – or if Russia chooses to completely cut gas supplies to Europe – then the Eurozone could slip into a recession.

There’s also a risk that by raising interest rates too quickly the ECB will stifle economic growth in the Eurozone.

Euro Area Fragmentation

Another key concern is fragmentation. There are 19 countries in the Eurozone, each with their own economies and financial institutions. The worry is that as the ECB normalises monetary policy, it could impact these countries differently. This would create financial instability across the bloc, causing turmoil for the single currency.

The ECB failed to address these fears in their June meeting, causing EUR to slump (after a brief spike). Meanwhile, signs of fragmentation are already emerging. The yield spread between Italian and German government bonds is the widest it’s been in two years, heading into the ‘danger zone’.

Widening yield spreads put more pressure on debt-stressed Euro-area countries, risking financial contagion across the bloc and undermining the Euro’s use as a shared currency. If the ECB fails to alleviate these fears, the Euro may struggle.

Ukraine Crisis

Of course, Russia’s invasion of Ukraine is a major factor driving huge amounts of uncertainty at the moment. The war grinds on, with its effects rippling out through the global political and economic climates.

As mentioned, disruption to Russian energy exports could have a devastating effect on the Eurozone economy. Other events could also impact EUR. If the conflict escalates or expands, spreading to other European countries, then the single currency could suffer.

Euro Exchange Rate Forecast

So, the path to tighter monetary policy is fraught with dangers, obstacles and uncertainties. While rising interest rates should see the Euro gain ground overall, expect EUR to have a rather wobbly climb.

In the meantime, there’s always the risk that some unexpected event comes and knocks the single currency off course…

Samuel Birnie

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