European markets see a grenade in the path of euro

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European markets see a grenade in the path of euro

LONDON Reuters -- The European Central Bank's latest comments on inflation have lobbed another grenade in the path of the euro.

The euro was down over 7% this year against the dollar after ECB President Christine Lagarde quashed money markets expectations for a 2022 interest rate rise. She said tightening policy would only choke off economic recovery.

She posits the euro against peers that are backed by policy tightening expectations - in the British pound's case, a rate rise may come as soon as next month. Markets are seeing the U.S. Federal Reserve hiking from mid- 2022, bets that have not been decisively rebutted by the Fed.

With the ECB still insisting that interest rates won't go up next year, there is not much point in trying to catch a falling knife, according to Kenneth Broux, Societete Generale strategist.

Since September, the rally in the euro has been sold resolutely and investors are not abandoning this tactic. The currency is at a 16 month low against the dollar of around $1.13. It is holding near levels not seen since the start of the epidemic against the pound, while it is nearing March lows compared to the Australian dollar.

It is near the 2015 lows against the Swiss franc despite Swiss interest rates being lower than the ECB's.

Near-term weakness is being priced in.

The bearishness of the derivatives markets, where traders often put on directional bets, indicates bearishness has grown in the past two sessions. One-month contracts for implied euro dollar volatility - now encompassing the ECB's December 16 meeting - have surged a whole percentage point in the past 24 hours.

There is a rise in risk premiums as a result of these swings in the currency.

Three months of euro risk reversals - a gauge of demand for options on a currency rising or falling - show the premium for calls at the lowest since May 2020 compared to Puts and calls allow holders to sell or buy respectively.

Expectations are for 12.5 bps of theECB tightening next year, down from 20 bps, which was spelled in by investors last week.

Retail sales beat forecasts in October despite higher inflation, despite expectations that the Fed will have to apply the brakes to a racing U.S. economy.

Mark Haefele, UBS Global Wealth Management's CIO, expects the dollar to strengthen broadly next year, leaving the euro valued at $1.10 by the end of 2022, according to Mark Haefele.

A 2022 rate hike was always a tall order for Europe, despite inflation running above the 2% target of the European Central Bank, while a recent spike in COVID 19 cases risks setting back growth.

The European surprise indexes compiled by Citi show European data lagging their U.S. equivalents by the biggest margin in over a year.

The Fed's liftoff may sweep along others, but investors seem unprepared for euro weakness.

The data shows that hedge funds turned long the euro in the last week, with a $1.4 billion shift in its favor. Some of the bets may melt away after Lagarde said something.

There are around $7 billion of options bunched around the $1.15 level for the end of November, and investors are positioned for euro strength in derivatives markets too.

That could change as the U.S. rate hike expectations increase.

The spread between euro zone and U.S. interest rate futures expiring in December 2022 is the widest since November 2020 in favor of the latter, and BofA Securities' monthly survey showed investors expecting 1.5 Fed rate hikes in 2022.

Jane Foley, head of FX strategy at Rabobank, said that the Fed could be hiking rates in the second half of 2022, making it hard for the euro to claw back much ground against the dollar.