Credit Agricole

Market hopes for decisive official steps to prop up the EUR have been on the rise of late with investors now looking for: (1) a more aggressive rate hike at the 8September ECB policy meeting; and (2) a cap on European energy prices to be debated at the 9September EU energy ministers’ meeting. If successful, the measures can cap the EUR rate disadvantage while helping European energy prices –and thus market fears of a severe recession –recede further in a boost to EUR-denominated assets. That being said, we think that the ability of any monetary policy normalisation and energy crisis measures to support the EUR would depend crucially on the coordination and complementarity between these policies.

In particular, any official support for businesses and households could avert a deep recession but ultimately prolong the period of high inflation in the Eurozone and thus could necessitate even more aggressive ECB tightening. On its own, the latter can reignite credit risks in the Eurozone periphery, test the limits of the ECB’s newly-created credit backstop facility and complicate any plans for fiscal support and monetary policy normalisation. We therefore think that any official EU intervention in the energy market could only become a durable EUR positive if it does not attenuate the short-and long-term fiscal position of the Eurozone governments. This can further enhance the credibility of the ECB’s TPI and allow the bank to stabilise the EUR by hiking more aggressively.

Also next week, the RBA and BoC should continue their rate hiking cycles, with the former hiking rates by 50bp and the latter by 75bp. Local rates markets are heavily priced for these scenarios, so the central banks’ rhetoric will hold more impact for the AUD and CAD. In the UK, Liz Truss is widely expected to succeed Boris Johnson as the new prime minister. Truss’ proposals to deal with the cost of living crisis have already unsettled the UK fixed income markets and seemingly boosted the appeal of the GBP as a stagflation hedge.

The relative resilience of US economic data and the FOMC’s commitment to controlling inflation have led us to raise our USD/JPY forecasts. That being said, we continue to think risks of Fed overtightening constrain upside in the exchange rate and have gone short USD/JPY. In the near term, focus will be on Fed speakers as well as the August non-farm payrolls and services ISM. With many Fed-related positives in the price, however, global risk sentiment should remain a key driver of the USD.