The dollar strengthened and the euro weakened in sideways trade on Tuesday, a day after European Central Bank President Christine Lagarde tapped down expectations of aggressive interest rate hikes that have spooked bond markets.
A more hawkish tone from both the ECB and the Federal Reserve last week caught markets off guard and sent yields soaring on euro zone and U.S. debt in anticipation rates could rise faster and higher than previously expected.
Currencies broadly traded little changed as the market awaits U.S. consumer price data on Thursday. Economists polled by Reuters forecast the year-over-year CPI in January was 7.3%.
The dollar index rose 0.2%, with the euro down 0.21% to $1.1418.
Expectations of a rate rise in tandem have caused some topsy-turvy market response not fully fleshed out in the price action, said John Kicklighter, chief strategist at DailyFX.
“It inevitably has to snap back to some sense of normalcy,” Kicklighter said, suggesting the notion of up to seven Fed rate hikes this year is too aggressive and unlikely to happen.
“Eventually the markets will have to back off of their extreme expectations and that’s probably what’s going to settle some of this drive and volatility,” he said.
The yield on 10-year U.S. Treasuries topped 1.97% on Tuesday, the highest since November 2019 and a jump from about 1.73% just two weeks ago.
Markets are pricing in more than a 70% chance of a 25 basis point hike and a nearly 30% chance for a 50 basis point hike when U.S. policymakers meet in March, according to CME’s FedWatch Tool.
“The market is broadly sideways as we wait for Thursday’s CPI, which everybody knows is going to be up,” said Marc Chandler, chief market strategist at Bannockburn Global Forex.
“It’s all about what’s going on in the debt market,” he said. “For the second day in a row the two-year German yield is softer, and that stops a nine-day increase. It had to do with Lagarde’s pushback yesterday.”
The German two-year bund surged to -0.328% on Monday, up from -0.654 on Jan. 25. The yield slid 0.4 basis points lower on Tuesday to -0.30%.
Bond concerns were particularly acute for the so-called peripheral economies in Europe where inflation-adjusted Italian yields are close to entering positive territory.
Lagarde struck a more cautious tone, saying high inflation is unlikely to get entrenched and ECB council member Pablo Hernandez de Cos on Tuesday said any central bank move “has to be gradual”.
“Can the euro go higher if periphery spreads blow out and if Italian 10-year real yields turn positive? Can the economy cope with that?” said Kenneth Broux, a strategist at Societe Generale in London. “That is the million dollar question investors are asking.”
Investors are looking carefully at the future trajectory between European and U.S. rates, as the Fed is likely to lift rates more than the ECB in coming months.
While money markets were pricing in as much as 134 bps in cumulative rate hikes from the Fed this year, analysts were expecting 50 bps in hikes from the ECB.
Still, the short-term outlook has tilted in favor of the single currency, with the widely watched bond yield spread between U.S. and German 10-year debt narrowing in late January to around 170 bps from an April high of 194 bps.
Bitcoin punched through its 50-day average to top $44,000 for the first time in nearly a month on Monday and held there in Asia for a gain of more than 17% in four sessions.