ECB to out-hike peers in 2023Should boost Euro exchange rate valuesBut expectations risk becoming elevatedOpening the door to 'dovish' surprisesEUR also looking stretched short-term

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The Euro was riding high against the Pound, Dollar and a host of other currencies on Thursday morning as investors bet the European Central Bank would raise interest rates again and signal further robust action was required to bring inflation down.

The Euro is the second-best performing major currency of 2023 as investors cheer rising Eurozone interest rates and an improved economic outlook for the region, although some strategists warn a maturing rally could leave it exposed to near-term downside risks.

"We believe the euro’s recent rally could run out of steam," says Dominic Schnider, Strategist at UBS as there is a risk that the ECB's "projections about forward guidance are less clear-cut" than investors might be expecting.

The ECB has been a source of support for the Euro since it said in December that markets were underestimating the scale of the interest rate hikes that were still required to bring inflation lower.

The message was reinforced on Monday when it was reported Spanish CPI inflation unexpectedly accelerated in January, a significant development as Spain has tended to lead the broader Eurozone's inflation dynamics.

But the ECB will also have to consider the ongoing war in Ukraine as a downside threat to the economy, the impact of the rate hikes that have already been delivered and rising U.S. recession risks.

"All eyes and ears will once again be on the communication. A rate hike of 50bp looks like a done deal. How far and how fast the ECB will go from there, is still unclear," says Carsten Brzeski, Global Head of Macro at ING Bank.

Another key concern will be how rising interest rates will impact borrowing rates in Italy and Greece, two economies that have proven sensitive to elevated rates in the past.

Euro exchange rates would likely hold recent gains if the ECB proceeds with a rate hike and delivers forecasts and guidance consistent with the need for determined further action at subsequent meetings.

But if the ECB were to surprise with 25bp, or signal it will consider slowing the hiking cycle in light of the risks, then the Euro could retreat as elevated rate hike expectations are pared back.

Above: ECB policy rate expectations have been steadily rising. Image courtesy of Goldman Sachs.

Money markets now show investors are priced for the ECB to deliver a further 150bp worth of interest rate hikes over the duration of the first half of 2023; more than any other developed central bank.

With expectations elevated, the prospect of downside surprises grows.

Strategists at TD Securities warn the Euro is looking extended at current levels, having risen by nearly 14% since September lows.

"The rub here is that EUR is tactically stretched, suggesting that if you missed the latest rally, then entry levels are poor. We continue to expect some stabilization and consolidation of the broad USD in the weeks ahead," says Mark McCormick, Global Head of FX Strategy at TD Securities.

But the majority of foreign exchange analysts we follow say Thursday's outcomes will unlikely alter the broader direction of travel in the Euro to Dollar exchange rate.

Market pricing shows expectations for a mere 20bp worth of rate hikes are expected from the Fed in 2023, meaning Wednesday's 25bp move could to be the last.

Above: The ECB is considered by markets to be the most hawkish of the major central banks at the start of 2023. Image courtesy of Goldman Sachs.

"The theme for the ECB is that they're finally breaking ranks with the Fed, underscoring the prospects of another strong showing for the EUR in the quarters ahead," says McCormick.

Although the Fed will likely end up with a higher terminal rate, it is the ECB that is currently raising rates at a faster pace, which matters for near-term currency market direction.

"The ECB remains licensed to hike. We expect hawkish comments by ECB President Christine Lagarde in order to prevent another drop in market interest rates. In this regard, it would help if the ECB were to clarify its reaction function and send a message that has a longer shelf life than just a few days," says Brzeski.

Beyond the interest rate hikes of the first half of 2023, markets will be assessing which central banks will cut interest rates.

The early and fastest cutters would likely see their currencies come under pressure, meaning if the Fed leads the cycle the Dollar could come under more sustained pressure.

"It is hard to see the ECB cutting interest rates again any time soon. Current market expectations about ECB rate cuts in 2024 are premature. If anything, these expectations, as reflected in dropping longer-term interest rates, are an additional argument for the ECB to stay hawkish," says Brzeski.

Sandra Horsfield at Investec says rate cuts in the Eurozone may follow in due course, but will likely only arrive in early 2024 as "we expect a later end to rate hikes than in the US and in the UK."

If the Fed and Bank of England enter rate-cutting cycles ahead of the ECB then the Euro would look supported against the Dollar and Pound for much of 2023.