Summary:

• EUR/USD moved back above the 1.02 level on Tuesday morning, following the release of reports that the ECB may consider raising rates by 50 basis points on Thursday.
• Convergence in US-EU natural gas prices helps ease European recession fears, supporting the common currency.
• But, uncertainty over Nord Steam one gas pipeline may act to cap gains in risk currencies ahead of this Thursday’s deadline.
• GBP rallies back above the 1.20 level ahead of this morning’s UK inflation data. Tuesday’s UK labour report slightly softer-than-expected.

 
We have been saying for some time that there was far more room for the ECB to exceed market expectations than many of its peers, and that appears to be giving the euro a leg up so far this week. A number of the major media outlets were reporting on Tuesday morning that ECB policymakers were considering whether or not to opt for a larger 50 basis point rate hike at its policy meeting this week, having said at the last meeting in June that the bank intends to raise rates by 25 basis points. This would be a pretty major turnaround for the typically cautious central bank, which has not raised interest rates at all since 2011.

While a 50 basis point hike from the ECB this week is far from a done deal, markets are now assigning the scenario a two-in-three probability, having barely even considered the notion this time last week. Much now may depend on developments in European energy supply. The European Commission warned on Tuesday that the Nord Stream one gas pipeline between Russia and Germany may not open after the planned maintenance ends on Thursday. Should this be the case, then a 50 bp rate hike from the ECB, and the general optimism that has swept through markets in the past couple of days, would be seen as an overreaction.

For now, however, most risk currencies are rebounding against the US dollar. Much of the rally in the greenback last week was fuelled by heightened bets that the Federal Reserve could raise interest rates by 100 basis points at their July meeting. This expectations have, however, faded (markets see less than one-in-five chance of a full percentage point move from the FOMC this month), which has triggered much of the retracement. Sterling, for instance, has benefitted from the broad dollar weakness, rallying back above the 1.20 level on the greenback.

Yesterday’s UK labour report was slightly softer-than-expected, although in line with a jobs market still in prime position to weather the storm from higher price growth. Today’s UK inflation data will be the next big test for sterling. Should we see another surprise to the upside here, then markets may start pricing in a 50 basis point hike from the Bank of England at its August meeting as a near certainty, which would undoubtedly provide support for the pound today.

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