06:11 AM EST, 02/20/2025 (MT Newswires) -- The euro is looking soft on the crosses and a new theme may be coming into play on the back of geopolitical developments, said ING.

United States isolationism means that Europe is going to have to ramp up defense spending sharply. The question is: who's going to pay for it, asked the bank.

Will spending be undertaken by the European Union or will a failure to reach any collective agreement put pressure back on local and national budgets? Italy could be in focus here with perhaps one of the greatest needs to increase defense spending and a debt-to-GDP ratio already close to 140%.

ING's rates strategy team feels that the recent narrowing in Italian-German sovereign bond spreads could well reverse as it dawns on investors that national governments will be paying the defense bill.

Some of these trends started to show through in financial markets on Wednesday, where European debt started to underperform. The bank is seeing a bearish steepening of European bond curves, where the German 2-10-year Bund curve, now at 38bps, has hit the highest level since October 2022.

ING is "wary" that the theme of increased government bond supply can pressure peripheral spreads and demand a new fiscal risk premium of the euro.

This comes at a time when there isn't much trade risk premium priced into EUR/USD either. There don't seem to be any immediate signs that U.S. consumer is about to crumble or that the Federal Reserve is about to pull the trigger on another rate cut, wrote the bank in a note.

Overall ING has a slight preference that EUR/USD stalls in the 1.0450/70 area and could drop to 1.0350 should markets start to see Italian longer-dated government bonds coming under pressure.

The eurozone data calendar Thursday sees February consumer confidence at 4 p.m. CET. No fireworks are expected. Despite low unemployment and high real wage growth in Europe, it looks as though the twin threats of trade and European security will keep European savings rates high and demand subdued, stated ING.

If European bond markets are going to sell off further, life may become even harder for United Kingdom Finance Minister Rachel Reeves, pointed out the bank. Reeves is going to provide a spending update on March 26 and needs to credibly argue how the government will hit its fiscal rule of a balanced budget in FY29/30.

Higher gilt yields mean a higher bar for a credible spending plan and questions whether she can present a plan that defers spending cuts to the later years, added ING. If gilt yields are pressing their January highs at the time of the March review, this means either: a) Reeves will need to deliver deeper spending cuts or b) U.K. asset markets get hit should her plans not look credible. Neither scenario is a good look for sterling (GBP) and that is why the bank doubts GBP/USD holds any near-term gains over the 1.26 area.

Wednesday, markets saw the first correction after several weeks of rally in Central and Eastern European (CEE) foreign exchange under the positive sentiment coming from the Ukraine negotiations. The bank believes the main driver of the rally was and still is sentiment only, while the fundamentals of the economy remain almost unchanged for now.

At the same time, ING has seen some rally in CEE rates while EUR rates are flat or higher. This leaves the market with a narrower interest rate differential across the board which it thinks will start to weigh on strong CEE foreign exchange once positive sentiment starts to fade.

As such, Wednesday could be the first day of this correction and Poalnd's zloty (PLN) and Hungary's forint (HUF) in particular may be vulnerable given the heavy positioning built up in recent weeks. Although the bank isn't calling for a significant correction, it believes that for now the rally is done and markets are pricing in most of the positives.

Any surprise will come rather on the negative side from these levels, according to ING.