Euro Bulls Call End to Currency Rout After ECB’s ‘Regime Shift’

(Bloomberg) --

The euro, pummeled to an almost two-year low last month as the war in Ukraine raged on, may have found a floor as the market prepares for the European Central Bank to put an end to an era of negative policy rates.

Money markets are wagering the ECB could raise its deposit rate to zero by December for the first time since 2014, and suggests strategies based on short-selling the currency to fund higher-yielding positions may be drawing to an end. The common currency has already staged a mini rally, surging more than 2% against the dollar as talks between Russia and Ukraine helped further shore up sentiment.

Just last month, analysts were speculating the euro would fall to parity with the dollar given Europe's geographical proximity to the war and its dependence on Russian energy. Now, egged on by policymakers who have reiterated that a rate-increase is possible this year to tame record high inflation, some traders are bracing for further gains.

“Talks between Russia and Ukraine have allowed FX markets to focus on other, more EUR-positive drivers like the increasingly hawkish ECB,” Credit Agricole strategists including Valentin Marinov wrote in a note to clients.

It marks a shift for the central bank, which has been seen as resolutely dovish in contrast to the Federal Reserve and the Bank of England. The change in tone has driven yields higher, helping erode the region's stock of negative yielding debt to below a trillion dollars for the first time since 2014.

Deutsche Bank AG said the market is still underpricing the positive effect of this “regime shift” for the euro. Santander sees a floor at $1.10, with the currency bolstered by more stable risk appetite and by the fact that further greenback strength looks capped now that markets have priced in Federal Reserve hawkishness.

New Range?

While the euro remains within a bearish trend channel since late May, it has been trading with a more bullish tone for the past three weeks. Momentum indicators like the fear-greed and the moving-average convergence-divergence gauges make a case for the currency to settle within a range capped by $1.09-$1.10 on the lower end.

That said, RBC currency strategist Adam Cole sees a “grind lower” for the euro over the course of the year, as bets for ECB rate hikes may be overdone relative to the Fed. Bank of America strategists including Michalis Rousakis see the euro-dollar pair falling further to $1.05 by end-2022 due to the policy divergence and a growth outlook that has been “substantially downgraded” amid the war in Ukraine.

Bears Retreat

Options bets, meanwhile, paint a less bearish outlook for the common currency. Risk reversals, a barometer of market positioning and sentiment, have unwound the move induced by the war in Ukraine and are trading at levels seen earlier this year.

Should the common currency manage to stay within the higher highs, higher lows pattern in place since early March, then risk reversals could extend their move toward parity, which represents a more balanced options exposure for investors.

Breaking Free

The breakdown in the correlation between the spot market and interest-rate differentials is also helping. The common currency has been advancing even as the spread between two-year U.S. yields and equivalent German notes widens. The pricing also supports the view that pricing for the Fed's hiking cycle pricing may have peaked.

Hot Inflation

Some euro bulls may also be holding out for the ECB to raise rates faster than is currently priced in. Medium-term inflation expectations are still rising, and make a case for a euro rally, especially following the hotter-than-expected inflation prints out of the region's largest economies last week.

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