To curb persistent inflation the European central bank (ECB) is expected to hike interest rates by 50 basis points in their July meeting and abandon their negative rates policy that has existed for more than a decade. Interest rate swaps are pricing in 140 basis points rate increase by the end of the year. Such aggressive tightening will pose a risk for Europe area indebted nation such as Italy. The 2-year yield spread between 2-year Italian bonds and Germany equivalent has raised to the highest level of the year. The ECB may not hike rates as the market expects since higher borrowing rates will pose a risk for the region indebted nations.
The ECB policy tightening will not be able to match with more aggressive federal reserve (FED). Implied interest rate from the 30-day federal funds futures expiring December 2022 indicates that, the FED will raise rate by another 250 basis points.
Periphery concerns and growth risk coming from income squeeze as a result of elevated energy prices will more likely make the ECB to rethink about their aggressive policy tightening as inflation rages. The FED will raise rates more aggressively than the ECB creating a policy divergence which will result to more pain on the euro.
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