s of last Friday, the dollar was trading at its strongest position against its major peers since June 2020, as markets rushed to price in as many of five interest rate hikes from the FOMC this year. So far, ECB President Lagarde has erred very much on the dovish side of things, insisting that the recent spike in Euro Area inflation is temporary and firmly pushing back against market pricing for hikes. Investors do, however, appear to be growing increasingly less convinced by the day that this view will hold in light of recent upside surprises in European macroeconomic data, notably on both inflation and the labour market. Tuesday’s German labour report for January beat consensus, with unemployment falling by 48,000 last month, much larger than the 6,000 drop expected.

The ECB’s Governing Council will be meeting on Thursday afternoon, with all eyes now on the tone of Lagarde’s press conference and the bank’s accompanying communications. In reality, it’s likely that Lagarde will hold the line for now, maintaining the bank’s recent stubborn view that price pressures will soon show signs of easing and that higher rates won’t be required any time soon. Whether investors would believe such rhetoric remains to be seen, particularly given growing signs of dissent among committee members. Futures markets have actually reacted rather aggressively to both Monday’s German inflation surprise and, to a lesser extent, yesterday’s unemployment figures, and are now pricing in almost 30 basis points of hikes in the ECB’s deposit rate by the end of 2022, up from a little over 10 bps a week ago. This has both lifted the German 2-year government bond yield to its highest level since March 2019, and helped EUR/USD rally back above 1.12.

Figure 1: German 2-Year Government Bond Yield (1-year)