Euro May Rise as EU Defense Splurge Offsets Tariffs: ECB Preview

The euro may rise even as the ECB cuts rates again if an EU defense spending binge beckons a hawkish tone

• The ECB is widely expected to cut interest rates again, hitting a 2% target rate.
• Markets are priced for a mildly dovish bias in ECB guidance amid tariff worries.
• The euro may rally if EU defense spending plans bring on a hawkish tone shift.

The European Central Bank (ECB) is expected to cut its target interest rate again this week. A reduction of 25 basis points (bps) in the benchmark deposit rate from 2.25% to 2% has been fully priced in by the markets, according to benchmark ESTR rate futures. For traders, this puts the spotlight on what the central bank is likely to do next.

As it stands, the markets are envisioning 34bps in further cuts this year, beyond this week’s adjustment. This comes to 25bps in additional easing along with a 36% probability of a third cut. Rates are expected to remain on hold next year. A modest tightening bias is reflected in markets are pricing in a 5bps uplift, which implies a 20% probability of a hike.

An ECB rate cut is coming, but what will happen next?

ECB watchers will have plenty to chew on as they consider whether this outlook still makes sense. Beyond the usual release of a policy statement from the Governing Council and a press conference with President Christine Lagarde, the central bank will issue the quarterly update of its economic forecasts.

Conflicting forces are at play. On the economic growth front, the currency bloc seems to be in dire straits. Purchasing managers index (PMI) data from S&P Global revealed that the manufacturing and services sectors both contracted in May. For the latter, this was the first decline since November. Taken together, this left the economy at a standstill.

Against this backdrop, inflation has fallen back to the ECB target. Preliminary figures for the consumer price index (CPI) said it grew 1.9% year-on-year in May, the lowest since a brief spike down to 1.7% in September. A rebound in energy’s contribution to overall price growth then pushed inflation up to 2.5% by January.

The euro may rise as the ECB eyes EU defense spending

The markets seem to envision that weakness will persist from here. Inflation expectations priced into German bonds have been falling since recently, with the benchmark 5-year rate sinking to levels unseen in over a year a well below the ECB target. This points to expectations for weak demand ahead.

It seems to make sense that this could foreshadow downward revisions in ECB growth and inflation forecasts. The March edition did not the majority of the US tariff shock that has since emerged. The Eurozone is a net exporter to the US, so the central bank may conclude that higher trade barriers will amount to a greater headwind than expected.

However, the slide in breakevens suggests the markets might have already priced in as much. On the other hand, the vast European Union rearmament plan envisioning 800 billion euro in additional defense spending represents an upside shock to both growth and inflation. Its first 150 billion euros were just approved by the European Council last week.

If the ECB takes a more hawkish stance with this in mind. That need not be dramatic, since the markets already expect tariff-related issues front and center. If baseline forecasts reflect countervailing concerns about reflation risk as growth gets a shot in the arm from fiscal largesse next year, the euro may get the green light for a rally.

Ilya Spivak, tastylive head of global macro, has 15 years of experience in trading strategy, and he specializes in identifying thematic moves in currencies, commodities, interest rates and equities. He hosts #Macro Money and co-hosts Overtime, Monday-Thursday. @Ilyaspivak

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