Latest / The European Economy Podcast with Fexingo: ECB, Eurozone, and Continental Markets / Why ECB Rate Hike Is Strengthening the Euro in 2026
Transcript
- Lucas: So the ECB hiked rates on Thursday — first time since 2023 — and the market reaction has been pretty interesting. Luna: Interesting is one word for it. The euro jumped about a cent and a half against the dollar in the hours after the announcement. Lucas: Right. And at first glance, that seems logical: higher rates, stronger currency. But the context matters. This hike wasn't because the economy is running hot — it was because energy prices are surging due to the Iran conflict, and inflation hit 4.2 percent in May. Luna: So you have a central bank raising rates in response to a supply shock, which is traditionally a tough call. And yet the euro is rallying. Lucas: Exactly. And I think the key is that markets are pricing in further tightening. The ECB signalled that this isn't a one-off. If inflation stays elevated because of energy, they'll keep hiking. So capital flows into euro-denominated assets are picking up. Luna: We're seeing that in the ETF flows. VGK, the Vanguard FTSE Europe ETF, is up 2.4 percent in the last five days. EZU, the iShares MSCI Eurozone ETF, up 2.7 percent. Lucas: Those are big moves for a week. And it's not just equities — bond yields are rising too, but in a way that's attracting foreign buyers because the yield pick-up relative to US Treasuries is narrowing. The ten-year Bund yield is up about 20 basis points since the hike. Luna: So the euro is getting support from both the rate differential and the fact that European assets look relatively cheaper after a long period of underperformance. Lucas: Right. But here's the tension: a stronger euro hurts exporters. If the euro keeps rallying, it makes German cars and French luxury goods more expensive in dollar terms. At a time when the Eurozone industrial sector is already splitting between North and South, that's a risk. Luna: And we saw that in the country-level ETF performance. EWG, the Germany ETF, is only up 0.4 percent in the last five days. Meanwhile, EWI, the Italy ETF, is up 3.4 percent. EWP, Spain, up 3.6 percent. Lucas: That's a fascinating divergence. Southern Europe — which typically benefits from a weaker euro because of tourism and exports to non eu markets — is outperforming. But Germany, which is more exposed to global trade and especially to China, is barely moving. Luna: So the rate hike is actually widening the North-South split in a different way than we've been discussing. It's not just about industrial production or bond yields — it's about currency exposure. Lucas: Exactly. And let's bring in the dollar side. The trade-weighted dollar index is at 120.1, which is very strong historically. That's actually part of the story — the dollar was already elevated, so the euro's rally from 1.12 to 1.15 is more of a correction than a dramatic shift. Luna: Right. And the dollar strength itself is partly a safe-haven bid from the Iran situation. So the euro is gaining despite that, which says a lot about how the market is interpreting the ECB's move. Lucas: It's a credibility play. The ECB is showing it will act on inflation even if it hurts growth. That's exactly what the Bundesbank used to be known for, and markets are rewarding that orthodoxy. Luna: But does it last? If energy prices keep rising, you could get stagflation — weaker growth, higher inflation, and then the ECB would have to choose between hiking into a recession or letting inflation run. Lucas: That's the million-dollar question. For now, the market is betting on a 'higher for longer' scenario where the ECB hikes a couple more times and then holds. The euro could grind higher to 1.18 or 1.20 if that narrative holds. Luna: But if growth deteriorates quickly, the ECB might have to reverse course. And then the euro would sell off just as fast. Lucas: Right. And that's why the next few data points are so important. We've got the Eurozone composite PMI next week, and then the July ECB meeting. If the PMI shows services holding up, the euro stays bid. If it crumbles, all bets are off. Luna: So for investors, the play isn't just 'buy the euro' — it's about which parts of Europe benefit from a stronger currency and which don't. Lucas: And that's where the stock selection gets interesting. Italian and Spanish banks, for example, tend to benefit from higher rates and a strong euro because their funding costs are in euros and they have large domestic loan books. Export-heavy industrials in Germany — not so much. Luna: We should also mention that this rate hike is happening against a backdrop of the UK economy shrinking 0.1 percent in April, which reinforces the idea that Europe is a mixed bag. Lucas: Yeah, the UK is its own story, but it does highlight that the ECB's move is somewhat contrarian relative to other central banks. The Fed is on hold, the Bank of Japan is still ultra-loose. So the ECB is really standing out. Luna: And that's why the euro is getting bid. It's not just about the rate hike itself — it's about the divergence in policy direction. Lucas: Exactly. If the Fed starts cutting next year while the ECB is still hiking, you could see a much bigger move in the euro. But that's a 2027 story. Luna: For now, the immediate takeaway is that the ECB has regained some credibility, and the euro is reflecting that. But the underlying energy shock is still unresolved. Lucas: And that's the thing — the Iran situation is fluid. If there's a diplomatic breakthrough, oil prices could drop sharply, inflation expectations would fall, and the ECB might not need to hike again. The euro would likely give back some gains. Luna: So the currency market is really a proxy for the uncertainty around energy and geopolitics right now. Lucas: Look, I think for our listeners who are trying to make sense of this, the key is to watch the correlation between the euro and oil prices. If they start moving together — euro up, oil up — that means the market is still in 'ECB credibility' mode. If they decouple, something has shifted. Luna: That's a good framework. I'll be watching that. Lucas: Me too. And if walking through these macro connections with us has made something click, we should mention that the show is ad-free by design. We don't run commercials — it's just the two of us and the data. If you find value in that and want to support it, you can find us at buy me a coffee dot com slash fexingo. No pressure, just an option. Luna: Yeah, it's a small way to keep this independent. We appreciate everyone who listens. Lucas: Alright, back to the markets. One more thing I want to flag: the euro's rally is also affecting the inflation outlook. A stronger euro makes imported goods cheaper, which could help bring down headline inflation over time. Luna: That's the feedback loop. Higher rates strengthen the currency, which then acts as a disinflationary force. So the ECB's job gets easier if the euro keeps rising. Lucas: Right. But it takes time — maybe six to twelve months for currency moves to feed through to consumer prices. So don't expect May's 4.2 percent reading to drop sharply in June just because the euro went up. Luna: And in the meantime, the export sector feels the pain. So it's a balancing act. Lucas: Exactly. And that's the story of European economics right now — a series of balancing acts. Rate hikes versus growth, currency strength versus export competitiveness, North versus South. The next few months will tell us which way the scales tip. Luna: On that note, we'll be watching the PMI data and the ECB's July meeting closely. Thanks for joining us. Lucas: Yeah, we'll be back tomorrow with another angle. Take care.