Joice Alves and Saikat Chaterjee

LONDON, (Reuters) – The latest remarks by the European Central Bank on inflation are yet another grenade against the euro.

The euro fell against all major currencies after Monday’s ECB President Christine Lagarde effectively quashed the money market expectations for a 2022 rate increase. She stated that tightening policies now will only impede economic recovery.

This stance puts the euro in direct competition with peers that are supported by tightening policy expectations. In the case of the British Pound, it may be possible for a rate increase to occur as early as next month. Markets see the U.S. Federal Reserve raising rates by mid-2022. This is a bet that has not been rebutted.

Kenneth Broux, Societe Generale strategist (OTC) stated that “the ECB is still insisting interest rates will not go up next year. There’s no point trying to catch a fall knife.”

Investors aren’t abandoning the strategy of selling euro rallies resolutely from September.

The dollar is hovering at $1.13, a 16 month low for the single currency. It is at levels that were not reached since the outbreak of the pandemic. However, it’s near March lows when compared with the Australian dollar.

It’s even near 2015 levels against the Swiss franc despite Swiss interest rates being less than those of the ECB.

Additional near-term weakness has been priced in.

The increase in bearishness of derivatives markets where traders frequently place directional bets has been evident over the last two sessions. Indicated euro/dollar volatility contracts of one month — which include the Dec. 16 meeting by the ECB — rose by a full percentage point over the last 24 hours.

They indicate a higher risk premium, and therefore more fluctuations in the currency.

The premium for calls is at its lowest level since May 2020, compared to “puts”. Three month euro risk reversals — which are a measure of the demand for options on currency falling or rising — shows the premium for “calls,” the highest in three months.

Holders can sell and buy with calls or puts.

Investors last week priced in 12.5 bps for ECB tightening, but now expectations are lower at 12.5 bps.

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A lot of euro bearishness can be attributed to expectations that the Fed will need to slow down a running U.S economy. Retail sales beat estimates in October, despite higher inflation.

Mark Haefele is UBS Global Wealth Management’s CIO. He expects that the greenback will strengthen in the coming year and the euro to remain at $1.10 until the end of 2022.

A rate rise of 2022 seemed a daunting task for Europe. This is despite inflation exceeding the ECB’s 2% target. While a recent increase in COVID-19 cases could lead to a decline in growth,

Citi has compiled economic surprise indexes that show European data trailing their U.S counterparts by the largest margin in more than a year.

Still, investors seem not prepared for weakness in the euro and are betting that the Fed will lift all others.

According to data, hedge funds have been “longing” the euro over the past week with an $1.4 billion shift in their favour. Lagarde’s remarks could cause some bets not to hold.

However, derivatives markets are also a good place for investors to gain euro strength. Investors have around $7Billion of options positioned around the $1.15 mark for November expiry.

As U.S. rate rise expectations grow, this could shift.

Spreads between U.S. and euro zone interest rate futures expiring December 2022 will be the highest since November 2020. BofA Securities monthly survey revealed that investors expect 1.5 Fed rate rises in 2022.

Jane Foley from Rabobank’s FX Strategy, stated that the Fed may raise rates by the end of the 2022. This could mean the euro loses ground against the dollar.