FX Daily: Three Takeaways After Crazy Euro Thursday

USD: Go up
A very turbulent day in the Eurozone resulted in high volatility but no real change in the overall G10 FX picture. The dollar is climbing across the board this morning, and we’re not surprised to see it.

We previously highlighted how the narrative of other central banks closing the gap with the Federal Reserve did not appear to be a realistic driver of sustained dollar depreciation, and yesterday’s post-ECB moves were likely an example of this, because they showed how: a) divergent growth prospects and exposure to geopolitical risks remain the main currency driver; b) the pricing of some G10 central banks – but not the Fed – is already very hawkish, limiting the possibility of hawkish surprises being transmitted via the domestic currency.

There is normally a bit of calm after the storm after such a big event, but the current market environment suggests that volatility should remain the name of the game in FX, at least during the summer months. Today the PMIs will be released around the world, and although they are not as popular as the ISM in the US, it will be interesting to see the numbers. The consensus appears to be for some stabilization in the gauges, with a contraction in gasoline prices perhaps offering some support.

We see the dollar potentially gaining some more ground today as markets begin to position themselves for a hawkish statement from the Fed next week, and the global macro situation continues to weigh on sentiment. Consolidation above 107.00 in DXY is our base case for the day.

EUR: Volatile Times Ahead
The ECB yesterday carried out a surprise rate hike of 50 basis points and announced the deployment of an anti-fragmentation tool called the Transmission Protection Instrument. Here is our economist’s take on yesterday’s announcements.

The euro went on a rollercoaster ride around the release of the statement and press conference. Here are our three takeaways:

First, it’s another testament to how the ECB’s warmongering is proving insufficient to sustain the euro. This is because the deteriorating Eurozone outlook and volatile risk sentiment continue to play a bigger role for the common currency. It also shows how the markets had gone too far with their hawkish pricing ahead of the meeting.
Second, the sovereign spread factor is now officially the Eurozone’s central theme. Indeed, the announcement of an anti-fragmentation tool and the establishment of relatively strict conditionality already (the fiscal rule may be the main cause for concern) means that markets may stop focusing on conditionality itself. even and rather look into the effectiveness of the tool. This is especially true against the backdrop of a collapse of Italy’s ruling majority and a rise in the BTP-Bund 10-year spread caused by domestic political issues. The ECB’s communication problems under the Lagarde era could continue to be a source of downside risk for the euro, which will now trade more in line with sovereign spreads.
Third, the end of forward guidance means that market pricing on ECB tightening has lost an anchor and can make it (and by extension, the euro): a) volatile; b) more responsive to data; c) more responsive to ECB speakers. In other words, the volatility of the euro should not fade this summer.
We’ll take a first look at the Euro’s new reaction function to data releases today as markets focus on Eurozone PMIs. Consensus expects a further decline, albeit fairly contained in size (52.0 to 51.0 in the composite gauge, according to a Bloomberg survey). Either way, some rally in the dollar could keep EUR/USD below 1.0200 today.

Update on Italy: the President of the Republic will formalize the procedure for early elections in the coming days. The date of the vote is fixed: 25 September. Expect this to be reflected in the cross-EUR volatility curve. Opinion polls suggest that the new Prime Minister could be Giorgia Meloni, leader of the populist right-wing Fratelli d’Italia party, but she would need the support of another right-wing party (La Lega) and the Forza Italia party of former Prime Minister Silvio Berlusconi.

GBP: eyes on the PMI indices

Markets will focus on UK PMIs today after June retail sales fell 5.8% year-on-year, more than expected. However, we doubt these numbers will change the market valuation around the August Bank of England meeting, with the swap market now fully pricing a 50 basis point move.

Expect Cable to be driven primarily by the USD leg and global risk momentum at this time. The risk of a move down to yesterday’s lows (1.1890) is high in our view.

CEE: the region remains on edge
The ECB’s decision did not turn out as badly for the region as we feared, although the situation remains precarious. We think EUR/USD downside risks persist despite the ECB’s bigger than expected hike. The most vulnerable right now, in our view, is the Polish zloty, which has lost 55-65 basis points on the short end of the IRS curve over the past few days, bringing the interest rate differential down to from mid-April. We believe that sooner or later the zloty will have to reflect such a change in its value and return to at least 4.80 EUR/PLN and, moreover, the market still has room to reduce its bets on further monetary tightening of the NBP.

Second, in our view, the Hungarian forint which, although strongly supported by the highest interest rate differential in the region, faces an uncertain geopolitical situation. Although the latest news from the Hungarian government on negotiations with the EU seems optimistic, we believe that it is too early to reach an agreement. At the same time, Hungary is the country most vulnerable to a potential cut in gas supplies from Russia, which the Hungarian government is tackling in Moscow, and will certainly not help in negotiations with Brussels. Additionally, the Fitch rating revision will be released today, and we believe there is a strong chance of a downgrade to the outlook. Overall, we therefore believe that the forint is having its heyday, but could very quickly rise above 400 EUR/HUF.

The Czech Koruna tested the EUR/CZK 24.60 level for the first time in 10 days, which may have triggered central bank intervention and is likely to repeat itself in the coming days. Expectations of further rate hikes from the CNB are fading and negative comments from some board members regarding FX tools may attract more short positions with a view to ending intervention soon. However, we believe that at the moment the Czech National Bank has little reason to change its current approach and this issue will be back on the table after the August meeting.
Source: ING