ING’s Francesco Pesole writes that Middle East tensions have modestly re-tightened EUR/USD short-term swap rate differentials by around 10bp, though the spread remains wider than pre-war levels. While this supports expectations for a potential September European Central Bank (ECB) hike, Pesole argues the path for a stronger EUR/USD is limited and warns of downside risks, including a possible retest of 1.140.

Rate spreads support but risks linger

"We expect stabilisation today – with markets potentially wanting to wait for weekend clarity – but risks are of a retest of 1.140."

"While all this is injecting new confidence into previously dwindling expectations for a September ECB hike, the path for EUR/USD to come out stronger from this re-escalation is quite narrow."

"The Middle East military re-escalation has prompted a moderate re-tightening in EUR/USD short-term swap rate differentials. In the two-year tenor (often the best correlated with FX moves), that has been worth roughly 10bp."

"That spread is still 50bp wider than its April peak, when markets bet heavily on ECB tightening but not on the Fed’s, but only 15bp wider than before the war."

(This article was created with the help of an Artificial Intelligence tool and reviewed by an editor. Know more.)