Growth worries & Fed policy seen weighing on EUR/USD Bond market losses in parts of Europe seen as risk factorECB policy at risk of placing Southern Europe in difficulty But new or novel ECB policy tools may negate concerns

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The Euro to Dollar rate has remained close to five-year lows even as market expectations have shifted in favour of a sharp uplift in European Central Bank (ECB) interest rates this year and HSBC says this likely reflects worries about the Eurozone economy and risks of financial fragmentation.

Europe’s single currency slipped briefly beneath 1.05 against the Dollar last week, marking its lowest ebb since the most acute phase of the coronavirus crisis and leaving it within arm’s reach of its 2017 nadir around 1.0344.

While the Euro to Dollar exchange rate was quick to recover above 1.05 ahead of the weekend, it has remained suppressed beneath 1.06 thus far in the new week and in spite of an increasingly widespread array of Governing Council members suggesting the ECB could be close to lifting its interest rates.

“One reason is that the FX market seems to think the ECB may be unable to deliver the precise degree of tightening that can tame inflation without causing too much of a hit to growth,” says Dominic Bunning, head of European FX research at HSBC.

“But the other issue for the ECB, which is becoming more prominent, is the fragmentation risk across the region whereby yield spreads between the core and the periphery are widening out quickly,” Bunning and colleagues wrote in a Tuesday research briefing.

Above: Euro to Dollar rate shown at weekly intervals.

Bunning and the HSBC team noted prominently on Tuesday that much of the Euro’s recent losses reflect a strengthening of the Dollar that is rooted in the aggressive policy change underway at the Federal Reserve (Fe) and which has been borne out just as markedly in other exchange rates too.

However, they also suspect that the darkening Eurozone economic outlook has been an additional and increasing burden during recent months and warned on Tuesday that as the announcement of any potential ECB interest rate rise draws closer, other risk factors could become pertinent too.

“It is out of our remit to comment on regional debt sustainability or Eurozone break-up risk specifically. But we are very aware that the FX market may look at these issues more closely if the spreads widen further, especially at a faster pace,” Bunning wrote on Tuesday.

“At this stage, it is too early to tell how strong or persistent it will be. But it is certainly another factor for the ECB to consider that other G10 central banks do not have to worry about,” he added.

The ECB presides over a monetary union between 19 different countries, some of whom are perilously indebted and some of whom aren’t, which poses a unique challenge to the bank as it recalibrates Eurozone monetary policy for an era in which low levels of inflation can no longer be taken for granted.

Above: Spread - or gap - between Italian and German government bond yields at 02 and 10-year maturities. Shows the extent to which Italian government borrowing costs have risen over and above the increases seen in German government financing costs. Click image for closer inspection.

This is in part because perceptions of differing degrees of creditworthiness among Euro area members often lead the market to treat their respective government bond markets differently and in ways that can complicate or potentially even prevent a uniform application of ECB monetary policy.

“We must ensure that monetary policy is transmitted evenly to all parts of the euro area. We are ready to use a wide range of instruments to address fragmentation, including the possible flexibility under the PEPP’s reinvestments,” Executive Board member of the ECB Frank Elderson said on Saturday.

Differing perceptions of creditworthiness and their varying impacts on government financing costs across the Euro area have in the past threatened some countries’ access to debt markets and taken a toll on the single currency, hence why such risks are already prominent in mind at the ECB.

This all comes as Europe's record high inflation rates and rising expectations among businesses and households are increasingly leaving the ECB with few choices other than to withdraw the extraordinary monetary stimulus provided in support of the Eurozone economies during recent years.

“In recent years, the monetary stance of the ECB has been determined by a combination of policy measures: the low level of the key policy rates, rate forward guidance, asset purchases and targeted lending operations,” chief economist Philip Lane told the economic policy think tank Bruegel last week.

Source: European Central Bank.

“The calibration of our policies will remain data-dependent and reflect our evolving assessment of the outlook,” Philip Lane also said.

But while rising interest rates would always put upward pressure on financing costs for all countries, they need not revive market concerns about market access and financial stability in the more fragile parts of the Eurozone.

That is not least because the ECB’s various quantitative easing programmes have left it with a multi-trillion portfolio of government bonds that has to be continuously reinvested into other Eurozone government bonds each time monies are returned to the ECB after one reaches its maturity date.

This is in turn something that could eventually prove useful to the bank when it comes to ensuring that rising interest rates, government funding costs and overall monetary policy are applied uniformly across the bloc, and this too is also something that hasn't gone unnoticed or unconsidered in Frankfurt.

“I think it's on the basis of that recognition of the value of flexibility, in particular in order to make sure that the monetary policy stance is properly transmitted and that unwarranted fragmentation is avoided, that we are recognising this and we are mentioning flexibility as one of the principles that we want to apply,” ECB President Christine Lagarde said in April's ECB policy press conference.