The ECB decided to raise interest rates for the 10th consecutive time yesterday, marking the entry into new territory for policymakers led by President Christine Lagarde.
The decision to bring the deposit rate to 4% came with the vague hope of bringing consumer-price growth below 2% at the very end of the ECB’s outlook in 2025.
One must keep in mind that by raising interest rates, the European Central Bank tightens the screws on a faltering economy.
The ECB is quite realistic in its assessment and believes that the economy is unlikely to grow until the end of 2023.
But the accompanying near-term message was far bleaker, as Lagarde admitted that growth will be “very, very sluggish” and forecasts acknowledged that the economy may even be on the verge of shrinking.
The danger for the ECB is that it was an excessive increase and financial markets are already betting on a reversal as early as next June.
“The difficult times are now,” Lagarde told reporters, explaining that more tightening was needed “not because we want to force a recession, but because we want price stability.”
Such remarks haven’t tended to play well in countries such as Italy, which is feeling the impact of higher rates and just suffered a quarterly contraction.
Germany is already largely in recession, and with it, other countries linked to the German system such as the Netherlands.
The problem for policymakers is that inflation — in their own words — is still anticipated to stay “too high for too long.” On both the headline gauge and an underlying measure that strips out energy and food, price growth is stuck above 5%.
Peter Praet, a former chief economist of the ECB, reckons the ECB's decision to raise interest rates for the 10th consecutive time signals a turning point for the markets.
Money markets brought forward bets on the timing of the first quarter-point interest-rate cut: almost three 25-basis-point reductions are priced across next year’s outcomes, the most since the start of the month.
“The hawks won the decision, but the doves won the market reaction,” said Karsten Junius, chief economist with Bank J Safra Sarasin in Zurich.
What practical trading conclusions can be drawn from this?
Most likely, the ECB has reached the pinnacle of its monetary policy tightening. Thus, easing is the only option. The question is the timing. Most likely, it is a prospect for the next year and a half.
How will the currency market, in particular EURUSD, react? Decrease of the ECB’s key rate will cause weakening of the European currency and a fall of EURUSD.
The final recommendation is a long-term sale of EURUSD — at least until the middle of 2024.
Profit or loss could be fixed in the summer of 2024.