Euro's Hawkish Premium Unwinds as ECB Fails to Deliver

The euro's strong performance may be threatened if the European Central Bank (ECB) fails to deliver on market expectations of rate hikes. According to Danske Bank, the ECB is likely to raise interest rates in September but will stop there, contrary to market predictions of further tightening.

This discrepancy between market expectations and actual policy could lead to a reversal of the hawkish premium in the euro, which has driven its recent gains against the dollar and pound. The bank notes that much of the euro's summer advance is based on an assumption of multiple rate hikes, with markets pricing in a September increase as certain.

However, Danske Bank believes the market has 'over-ordered' rate hike expectations. They expect a final rate hike in September but do not see further tightening beyond that due to concerns about persistent inflationary pressures triggered by the war.

The euro's resilience is also attributed to the strong performance of European equities, which have been driven by positive earnings and revisions. This growth resilience acts as downside protection for the currency, as an ECB that stops hiking into a positively surprising economy is less bearish than one that stops due to economic weakness.