Euro falls, bonds gain as traders cut bets on future ECB hikes

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(Bloomberg) – The euro slid and bonds rallied as traders cut bets on future interest rate hikes after the European Central Bank adopted a more dovish tone in delivering its second straight hike .

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The euro fell 1.1% to below parity with the dollar and Italian debt led gains after the decision, pushing the deposit rate to 1.5%. Markets have been expecting a rise of this magnitude for weeks as policymakers try to rein in record inflation.

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While the ECB said it planned to raise interest rates further, it adopted a slightly less hawkish tone. That led money markets to cut bets on rate hikes by up to 27 basis points, pegging a peak of 2.65% next year, down from nearly 3% before the ECB’s announcement.

“Doves gained some flexibility in forward guidance today,” said Jordan Rochester, currency strategist at Nomura Holdings Inc. “It’s not just an inflation story anymore. Combine that with the BOC yesterday and it looks more and more like a global central bank pivot.

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The Bank of Canada raised rates 50 basis points on Wednesday, a smaller move than expected.

Traders’ attention turned to ECB President Christine Lagarde’s press conference, and in particular any indication that policymakers might come up with a lower hike in December. Lagarde warned that global activity continues to slow and a massive terms-of-trade shock is weighing on earnings in the euro zone.

“Lagarde basically recognizes that the risks of stagflation are on the rise for the eurozone,” said Lars Merklin, currency analyst at Danske Bank. “In this environment, the euro-dollar is likely to weaken further.”

German bonds posted gains across the board. The two-year note – among the most sensitive to interest rate changes – led the rally, dragging the yield down as much as 17 basis points to 1.78%, a reversal after rising as much as 11 points base earlier. The 10-year yield fell below 2% for the first time in about three weeks.

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The ECB said bond reinvestments under its asset purchase program would continue in full for as long as necessary. Lagarde said policymakers will decide on principles for reducing his portfolio in December, a commitment that follows anticipation of such a timeline.

“While its US and UK counterparts act to shrink the size of the balance sheet, the ECB is taking a different path and avoiding the path of quantitative tightening,” said Jeremy Batstone Carr, European strategist at Raymond James. “A bigger priority for the ECB will be the trend in bond yield spreads between peripheral and core member states.”

Italian bonds outperformed, reducing their yield premium over German Bunds by 13 basis points. Policymakers are watching Italy’s borrowing costs given that it is one of the most indebted countries in the region.

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Authorities also tightened the terms of more than 2 trillion euros ($2 trillion) in ultra-cheap pandemic-era loans to banks known as TLTROs. The deals had become problematic after recent rapid rate hikes allowed lenders to park TLTRO cash in ECB accounts and earn risk-free income.

It’s a matter of concern to banking stocks, with Deutsche Bank AG’s chief financial officer saying ahead of the decision that he was “disappointed” that the central bank wanted to retroactively change the rules. Commenting on the bank’s earnings call, he said it was not a windfall profit after banks battled negative returns for years.

—With help from Greg Ritchie.

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