June ECB Cheat Sheet: How To Train Your Hawks

Here are our four scenarios for the 11 June ECB meeting, alongside implications for rates and FX. We think the ECB's current priority is solidifying markets' expectations on further tightening to hedge against inflation expectations de-anchoring. Our baseline is therefore a hawkish hike, with some indications the bank is prepared to raise rates again.

This is our market preview of June’s ECB meeting; you can find our macro team’s preview here.

Scenario analysis: How to position for Lagarde’s alternatives

The ECB is set to hike rates by 25bp on 11 June. Recent communication has effectively pre-committed markets to this outcome. A hold would come as a shock and carry significant risk for a central bank trying to avoid a repeat of the 2022 inflation crisis.

As such, our four scenarios for this meeting (above) exclude anything other than a 25bp move. A 50bp hike could be included as an ultra-hawkish outcome, but there is already additional tightening priced in for later this year, which means shocking markets now seems unnecessary.

Focus on keeping markets hawkish

Markets are fully pricing in a 25bp hike, so focus will be on forward-looking language – effectively a reality check on the 64bp of total tightening priced in by year-end. The Governing Council and President Christine Lagarde will, in our view, share a key objective: to preserve these hawkish market expectations.

That’s because the June move looks more like insurance than conviction. The risk of second-round inflation effects remains as hard to estimate as the next chapter for the Gulf conflict and energy prices. Inflation forecasts, typically central to the ECB reaction function, are now heavily driven by oil prices and therefore less reliable in this environment. We think the real battleground for the ECB now is inflation expectations. They are a function of rate expectations, and unless the ECB keeps those hawkish, it risks de-anchoring.

So our baseline is a hawkish hike at this June meeting. Not so much because the ECB is necessarily planning or willing to commit to another hike in July, September, or the fourth quarter, but because it is the most prudent play as it waits for clarity on geopolitics, energy, and the data. Our macro team has acknowledged rising risk of a follow-up move in September, but our baseline remains that this June hike is a one-and-done.

Rates: ECB should tread carefully to keep inflation expectations anchored

Markets are already fully pricing in this hike, but we think a confirmation could still add more upward pressure on the curve. When paired with forward guidance about future hikes, we see rates nudge slightly higher. More emphasis on inflation risks could increase markets’ pricing of inflation too, adding to the upward pressure.

A (too) dovish outcome risks feeding future inflation expectations, paradoxically adding upward pressure on rates further out the curve. This would entail a significant steepening with 2-year rates edging lower on less tightening, but a sticky 10-year rate on the back of inflation concerns further out the future. A ‘one-and-done’ narrative would strongly push against the positioning of current markets, which have already priced in a second hike by September. The ECB should therefore likely prefer to come across as too hawkish rather than too dovish.

Markets are also sensitive to the growth outlook and have been moving on ECB comments regarding the risks. So far, market sentiment has been very positive, helped by strong US equity performance. But the balance is fragile and an ECB voicing more worries about the growth outlook could pose some downward pressure across the entire curve.

FX: ECB hawkishness can reinforce floor for EUR

Short-term rate differentials have regained explanatory power in our EUR/USD short-term fair value model. That is likely a result of a hawkish Fed repricing while ECB tightening bets were being questioned. The rewidening in the EUR:USD two-year swap rate differential has been sizeable – roughly 25bp since end-April.

That differential is now pointing down for EUR/USD – other things equal – but still allows for a spot at 1.160+ as long as oil remains well-behaved. A hawkish ECB hike on 11 June should keep that equilibrium in place. It would also increase the upside potential for EUR/USD if the Strait of Hormuz reopens, counting on a higher base for EUR short-term rates.

So, if we are right with our baseline view, there are upside risks on meeting day for EUR/USD, with a firmer near-term outlook. We remain slightly bullish into summer, targeting a gradual move back to 1.180 in a de-escalation scenario.