ECB Faces Pressure for Faster Rate Cuts as Investors Bet on Weaker Euro

Investors are increasingly positioning themselves for a significant weakening of the euro, possibly pushing it below absolute parity with the US dollar.

With concerns mounting over the impact of potential US tariffs and political instability in the eurozone, market participants anticipate that the European Central Bank (ECB) will need to accelerate interest rate cuts to sustain economic growth.

Market sentiment reflects expectations that the ECB will adopt a more aggressive easing strategy, diverging from the US Federal Reserve’s approach. Currently, the euro trades around $1.04, but traders are preparing for further declines. At the same time, investors are eyeing a potential rise in bond prices in the coming months, assuming the ECB follows through with its expected monetary policy adjustments.

A widely anticipated quarter-point rate cut is expected after the ECB's meeting on Thursday, January 30. Investors will be closely monitoring any changes in policymakers' rhetoric, looking for indications of a shift in stance. The consensus market view suggests the ECB will proceed with three additional cuts by the end of the year, bringing the deposit rate down to 2%. This marks a clear contrast with the US Federal Reserve’s current policy stance, but some strategists believe the gap could expand further, particularly if US President Donald Trump imposes punitive trade tariffs on European goods.

Should the US proceed with tariffs, the ECB may be forced into deeper rate cuts to cushion the economic impact, further weakening the euro. Meanwhile, the US dollar is expected to remain supported, as the Fed would likely maintain higher interest rates to counteract any inflationary pressures caused by the tariffs.

Market data indicates that the cost of hedging against a weaker euro through the end of the year is at its highest level since June. Demand for options that provide strong returns if the currency falls to absolute parity has more than doubled this month compared to November and December, according to figures from the Depository Trust & Clearing Corporation.

Constantine White, portfolio manager at Pacific Investment Management Co., highlighted the risks facing the eurozone, stating, “We see additional downside risks to eurozone growth following the US election and the potential for lower interest rates than currently priced in.”

However, ECB policymakers remain divided on the necessity of deep cuts. François Villeroy de Galhau, governor of the Bank of France, has downplayed the urgency for drastic reductions in interest rates. Adding to the uncertainty, data released on Friday showed an unexpected rebound in the eurozone's private sector, which expanded in January after two months of contraction, contrary to analysts’ expectations.

Despite recent fears, the euro has gained more than 3% over the past two weeks, fueled by speculation that the US may delay or soften its tariff measures. The rally accelerated on Tuesday, January 28, following Trump’s remarks about introducing “much higher” horizontal tariffs exceeding the existing 2.5% rate.

Political developments within Europe are also adding to market uncertainty. In France, the newly formed government is facing challenges in passing its budget through a divided parliament. Meanwhile, in Germany, voters will head to the polls in February after Chancellor Olaf Scholz’s coalition government collapsed in November.

Further economic data, set for release just hours before the ECB’s policy announcement on Thursday, is expected to reveal sluggish eurozone growth. A Bloomberg survey projects that the region’s GDP grew by only 0.1% in the fourth quarter, a sharp slowdown from the 0.4% expansion recorded in the third quarter.

Nicolas Julien, global head of fixed income at Candriam, emphasized the importance of upcoming developments, noting, “The ECB meeting in March will be particularly important once the first steps of the US administration and the outcome of the German elections are known.”

Despite the ongoing uncertainty, Candriam maintains a broadly positive outlook on core eurozone government bonds, citing a more predictable downward inflation trajectory in Europe compared to the US. Market estimates of long-term inflation expectations in the eurozone remain stable at around 2%, while US inflation projections continue to fluctuate.

The US Federal Reserve, for its part, is expected to keep interest rates unchanged at its meeting on Wednesday. 

By fLEXI tEAM