The European Central Bank is expected to resume tightening after a seven-meeting hold, with markets focused on a 25 bps increase that would take the policy rate to 2.25%. The move comes as Eurozone inflation metrics continue to run firm: core CPI rose in May to a 13-month high of 2.5% y/y, closer to the ECB’s Q2 severe scenario of 2.4% than its baseline of 2.2% or adverse scenario of 2.3%. Services CPI also climbed to a seven-month high of 3.5% y/y, reinforcing concerns about persistence.
Attention is also on the ECB’s June projections, where growth forecasts are expected to be revised down. Survey evidence points to weaker activity, with PMI data implying real GDP could fall by -0.2% q/q in Q2, which sits between the adverse scenario of -0.1% and the severe scenario of -0.3%, and remains below the current baseline projection of +0.1%. Against that backdrop, EUR/USD is expected at 1.1400, even as higher rates may limit the downside in a soft-growth, higher-inflation setting.
ECB Rate Decision and Inflation Pressures
We believe the European Central Bank is poised to end its pause with a 25 basis point rate hike this month, bringing the main policy rate to 2.25%. This comes as May’s core inflation data was unexpectedly strong, hitting a 13-month high of 3.1% and confirming that price pressures are not yet contained. The services inflation component, in particular, remains stubbornly high, forcing the central bank’s hand.
This tightening is occurring against a backdrop of deteriorating growth. The latest Eurozone flash PMI for May fell to 49.5, signaling a contraction in business activity, while German factory orders have also shown recent weakness. This contrasts with the U.S., where the most recent non-farm payrolls report showed a healthy addition of over 200,000 jobs, underlining a clear economic divergence.
Market Implications and Trading Strategies
For traders, this stagflationary environment points towards a weaker euro relative to the dollar. We see EUR/USD, currently trading near 1.0950, as vulnerable to a decline towards a target of 1.0700 in the coming weeks. Buying EUR/USD put options is a straightforward way to position for this expected drop while managing risk.
The rate hike itself presents an opportunity in interest rate markets. We are positioning for this by shorting short-term Euribor futures contracts, anticipating that the market will fully price in the ECB’s hawkish stance. Historically, central banks facing persistent inflation often have to tighten more than initially expected, even into a slowdown, a pattern we saw in previous cycles.
Given the conflicting economic signals, we expect increased volatility around the ECB’s upcoming meeting. Traders should consider using option spreads, such as a bear put spread, to lower the cost of entry and define risk. This allows for a targeted bet on a weaker euro without being over-exposed to a sudden shift in market sentiment.
