We’d been warning for some time about the large gap between market expectations for future ECB rates and the inflationary reality. The central bank swung clearly to our view at its meeting last week, warning of 50bp hikes for as long as is necessary and forcing European rates higher across the curve. The Federal Reserve was also hawkish, and the Bank of England maintained its unblemished track record of muddled messaging and general confusion. The euro benefited the most, while sterling, emerging market currencies and risk assets generally reacted badly to the news that the two most important central banks continue to focus exclusively on reining in inflation back to targets. The week before Christmas tends to be on the dull side in financial markets, as traders wind down for the year. In fact, little news of note will come out next week, beyond the PCE inflation report in the US on Friday. However, the market is still digesting the hawkish surprises from last week’s central bank meetings, so we still expect an interesting week in currency markets.


While rates in the UK were hiked by 50bps as markets expected, there was a three-way split among Monetary Policy Committee members, with one member voting for a 75bp hike and two more voting for no change in rates. This was, at the margin, a dovish split, but on the other hand there seemed to be yet another swing in Bank of England communications, this time towards hawkishness and acceptance of higher market expectations of future hikes. Overall a muddle message that resulted in an underperforming currency as sterling finished the week right near the bottom of the G10 currency rankings. No major news will be released this week, so expect the pound to move off events elsewhere.


The ECB sent markets an unmistakably hawkish message last week, validating our view that there was a massive gap between expectations of future hikes and the inflationary realities in the Eurozone. President Lagarde warned of 50bp hikes, harsher and earlier quantitative tightening, and a higher terminal rate for the ECB. Another positive factor for the euro were the December PMIs of business activity, all of which improved measurably from the previous month. The worst-case scenarios for an energy crisis look increasingly remote, and China’s pivot away from zero-COVID policies only adds to the bullishness (relatively speaking) on the Eurozone economy. However, the common currency has already had a blistering rally of over 10% since its late-September low and perhaps a pause is to be expected in the lead up to the Christmas holiday.


The dollar was buffeted last week by two opposing trends. On the one hand, the November inflation report confirmed that core inflation is now decelerating gently and that we may have seen the medium-term peak in inflation. On the other, the Federal Reserve made it clear that this is not enough to justify a dovish pivot and that inflation continues to be the overwhelming focus of the central bank. The famous “dot plot” suggested a terminal rate of 5 to 5.25% and no cuts at all for 2023. In the end, the ECB was deemed by markets to be the more hawkish of the two institutions and the euro came out the winner, though in trade-weighted terms the dollar ended the week essentially unchanged. We will now be paying close attention to the PCE inflation report on Friday, to see whether it confirms the downward trend in the stickiest components of inflation in the US.