FX Daily: Euro Already Prices A Hawkish ECB

The dollar remains reasonably well bid even as May US CPI data eases some concerns about second-round effects and a more hawkish Fed. The focus today will largely be on the ECB meeting, where a 25bp rate hike is fully priced. Aggressive market pricing for ECB tightening this year suggests the euro will struggle to benefit from hawkish rhetoric today.

USD: Dollar holds its bullish bias despite US core CPI

Price action in interest rate markets is telling us a lot about sentiment. Despite yesterday's US May core CPI reading of 0.2% month-on-month, which allayed fears of second-round effects, markets are still pricing in a 25bp Fed hike by year-end. Equally in the euro rates space, our rate strategy colleagues note that short-dated EUR swap rates have lost their tight correlation with crude oil and remain very elevated. In short, it looks like it will take a lot to shake off the narrative that central banks will react to the current energy price shock.

US input into that story comes in the form of May PPI data today. Remember that parts of the PPI release, such as healthcare, financial services, airfares and insurance, feed into the Fed's preferred measure of inflation, the core PCE deflator, which is released on 25 June. Last month, the core PCE deflator rose to 3.3% year-on-year, further away from the Fed's 2% target. And another strong set of PPI readings today stands to keep short-dated interest rates and the dollar supported as we head into next Wednesday's FOMC meeting.

In the background, emerging currencies in Asia continue to struggle. Portfolio outflows are weighing on the tech-sensitive Korean won and Taiwan dollar. We have not touched on the idiosyncratic sell-off in the Indonesian rupiah recently, but Tuesday's emergency rate hike by Bank Indonesia has failed to quell many concerns over local policy decisions there. Of course, there is also a lot of focus on USD/JPY, which looks to be sitting comfortably above 160. For reference, speculative positioning data show net yen shorts running at around 25% of open interest. During the Bank of Japan's successful FX intervention campaign in 2024, which was helped by the Fed swinging dovish, speculative yen shorts were above 50% of open interest. This serves as a reminder that Japanese authorities have their work cut out in turning this USD/JPY trend around.

Also, a quick word on USD/CAD. The Bank of Canada continues to sit at the dovish end of the spectrum, using phrases like 'excess supply' in the economy and 'looking through' inflation in yesterday's policy update. This could see USD/CAD head back to the 1.40 area and keep a cross rate, like CAD/NOK, under pressure given the more hawkish position of Norges Bank.

DXY remains bid near 100. Assuming that the ECB does not strongly hint at possible back-to-back hikes in June and July, we think the PPI story can nudge DXY towards the 100.25/35 area.

EUR: A high bar for the ECB to lift the euro

The market expects a hawkish ECB meeting today, including a 25bp hike in the deposit rate to 2.25% and plenty of hawkish rhetoric. The ECB has spoken and the market has listened in recent weeks. This means that today's hike is fully priced into money markets, with another 25bp hike priced by September. A further hike is priced early next year.

Pricing a 75bp tightening cycle in response to a stagflationary shock may be as far as pricing can go at the moment. Unless the ECB hints that it might need to hike again in July (8bp is priced so far), the prospects for higher short-term EUR swap rates to lift the euro today look limited.

Short-term resistance at 1.1565/75 may be enough to contain the EUR/USD upside today. And 1.1500 could come under pressure if the US PPI data comes in hot.

TRY: Hawkish tone remains

The Central Bank of Turkey is likely to leave rates unchanged at 37% today. Governor Fatih Karahan recently stated that the current policy stance, marked by a tighter monetary approach maintained for longer than initially anticipated prior to recent geopolitical developments, remains appropriate. He also underlined that all policy options continue to be available. This approach signals a clear intention to preserve flexibility in policymaking amid evolving geopolitical conditions.

Against this backdrop and considering the recent macroprudential tightening through reduced lending growth caps, along with contained retail foreign exchange demand, we expect the central bank to leave interest rates unchanged at today's MPC meeting. However, ongoing geopolitical uncertainties, as well as domestic political dynamics, may prompt a more cautious stance, potentially resulting in an upward adjustment of the policy rate from 37% towards the current effective funding rate of around 40%.

The market quickly shook off the May pressure on the Turkish lira. CBT kept the USD/TRY spot unchanged and FX implied yields have almost returned to previous levels. FX reserves fell by around US$8bn in the same period, suggesting a smaller cost compared to the start of the US-Iran conflict or March last year. With the difficult disinflation story of the last few months and the CBT’s visible efforts to keep FX stable, it is clear that the current FX regime is here to stay. FX reserves remain high, and despite the thinning FX carry, TRY remains a popular trade in the EM space, which we believe will not change in the coming months.

At the same time, the widening current account deficit clouds the longer horizon and poses a problem for CBT in the future. We expect USD/TRY to be at 53.00 by the end of the year.

CEE: Different central bank paths lead to different FX

Core inflation in the Czech Republic rose slightly from 2.8% to 2.9%, a tenth above the Czech National Bank forecast. This is probably not a big game-changer, but it does give the Czech National Bank another small nudge toward a rate hike next week. Bank Board member Jan Prochazka indicated yesterday that the decision for him is 50:50 between no change and a rate hike. We believe that he belongs to the rather dovish side of the board, indicating a rather hawkish leaning of the overall board, increasing the probability of a rate hike next week.

Conversely, in Poland, we are getting different views from the Monetary Policy Committee regarding the direction of the next National Bank of Poland rate change. Overall, however, it seems that any change in rates is not on the table for the coming months. Apparently, the latest inflation print, which surprised on the downside at 3.1%, brought calm to the MPC and wait-and-see is now the best expectation.

In Hungary, May inflation also surprised to the downside at 1.8%, which cements the rate cut expectations for the meeting in two weeks. Moreover, after such a number, a 50bp step cannot be ruled out due to the 3% inflation target and the continued strengthening of the FX. However, the baseline for us remains a rate cut of 25bp in June and 75bp of easing overall this year. Unsurprisingly, the market is pricing in a bit more given the size of the surprise in inflation.

The FX space has been more of a secondary market after the rates market in recent weeks and, in our opinion, there is no choice but to follow local differences. The CNB hiking story will attract CZK buyers, which paints a bullish case here. EUR/CZK will test levels below 24.00 in our view. On the contrary, the NBP has flipped to the dovish side, significantly pushing back against the general expectation of rate hikes in the EM space and pushing EUR/PLN up to 4.265, the upper limit of the current ranges. EUR/HUF is still being pushed down by positive sentiment after the general election, and we keep 350 as a target for mid-year.