Why the euro rallied, despite Lagarde’s dovish rate view

EUR/USD rose sharply on Thursday following a combination of disappointing US growth data and a slightly uncharacteristic pre-commital to tightening from ECB President Christine Lagarde.

Lagarde’s press conference was a little bit of a mixed bag. We think that she again sounded dovish on inflation, continuing to reaffirm the bank’s view that price pressures would ease over the course of next year. The bank also still sees inflation below its 2% target over the medium-term. She did, at least, acknowledge that this decline in inflation would take longer than previously anticipated, due in large part to the persistence of supply bottlenecks. This is a slightly more hawkish assessment than we received in September.?

The ECB does, however, remain very dovish on interest rates. As we thought that she might, Lagarde pushed back against market expectations for rate increases. Prior to the meeting, futures markets were pricing in around 10 basis points worth of hikes in the ECB’s deposit rate by the end of next year, and 40 basis points by the end of 2023. According to Lagarde, under the bank’s current analysis, the conditions for a lift-off in rates are ‘not satisfied’, nor will they be in the near future. This is a very dovish signal, particularly at a time when most other G10 and EM central banks are delivering hawkish surprises - notably the Bank of Canada on Wednesday.

Instead of selling off sharply, the euro actually rallied against its major peers. We attribute this to two factors: firstly, investors were already bracing for an ultra-dovish message going into the meeting, and Lagarde’s pushback against higher rates was seen as a rather timid one. Moreover, Lagarde also stated that she thought the bank’s PEPP programme would end in March - there were some market participants that had expected a short extension to be announced in December. This commitment (of sorts) to tighten policy may partly explain the move higher in yields and the common currency, although the overall dovish message on rates makes us increasingly less confident in our bullish EUR/USD view.

US growth slows more than expected in third quarter

The dollar also sold-off against every other G10 currency yesterday, after the latest US GDP data fell short of market expectations. US growth eased to 2% annualised in the third quarter, below the 2.7% consensus, and a considerable slowdown from the 6.7% expansion posted in Q2. A confluence of factors appeared to weigh on activity, notably the delayed reopening in some states due to the spread of the delta variant.?

Acute supply shortages in many sectors and concerns surrounding rising inflation, which spent the entirety of the quarter above the level of earnings growth, have also weighed on the outlook. We do, however, remain relatively optimistic on the US outlook, and think that activity may pick-up in the current quarter. New daily US covid cases have roughly halved since early-September, while a strong labour market should continue to support consumer spending. Data out on Thursday showed that jobless claims fell again last week, down to 281,000 - a fresh pandemic low.?

Figure 1: US GDP Growth Rate Annualised (2016 - 2021)

Source: Refinitiv Datastream Date: 29/10/2021

Meanwhile, this morning’s Eurozone inflation numbers for October beat expectations. The headline rate rose to 4.1%, while the core rate jumped above the ECB's target for the first time since 2003, making yesterday’s dovish ECB message increasingly hard to justify.