Tariff clouds looming + Political turmoil continues, traders bet that the European Central Bank will embark on an aggressive rate-cutting path

According to the Zhitong Finance APP, due to the pressure on the European economy from U.S. tariffs and political turmoil in the region, traders are betting that the European Central Bank (ECB) will have to adopt a more aggressive approach to interest rate cuts. The market expects the euro to weaken, potentially falling from the current level of around 1 euro to 1.04 dollars to below 1 dollar, while bonds are expected to rise in the coming months as the ECB relaxes its interest rate policy. The market generally anticipates that the ECB will cut rates by 25 basis points on Thursday, and traders will closely monitor any shifts in policymakers' positions.

Currently, the market's baseline scenario predicts that the ECB will cut rates three more times before the end of the year, bringing the deposit rate down to 2%. This has shown a divergence from the Federal Reserve, but some strategists indicate that if U.S. President Donald Trump's punitive trade tariffs threaten to materialize, this gap will widen further and more quickly.

U.S. tariffs on goods imported from Europe may force the ECB to cut rates further to support economic growth, thereby harming the euro in the process. Meanwhile, the dollar will be supported as the Federal Reserve maintains high interest rates to offset the potential for tariffs to reignite inflation in the U.S.

Tim Brooks, head of foreign exchange options trading at Optiver, stated, "As long as a tariff on Europe is announced, the exchange rate will return to parity." In the long term, market participants are "seeking to hedge against the possibility of the euro weakening against the dollar and falling below parity."

Risk reversals are a closely watched barometer reflecting positions and sentiment in the options market, and this indicator shows that the cost of hedging against a weaker euro before the end of the year is approaching its highest level since June. Data from the Depository Trust & Clearing Corporation indicates that demand for options related to the euro depreciating to parity or lower against the dollar has more than doubled this month compared to trading volumes in November and December.

This cautious sentiment has also permeated the interest rate market. Traders have bet on a large number of options, believing that the ECB will cut rates by at least 50 basis points before mid-year, accelerating from the current pace of 25 basis points. One market participant purchased an options strategy targeting a deposit rate of 2% by mid-year.

Konstantin Veit, a portfolio manager at Pacific Investment Management Company, wrote in a report, "We believe that after the U.S. elections, the eurozone's economic growth will face more downside risks, and the eventual interest rates may be lower than currently expected."

Policy Shift

It is certain that one of the more neutral policymakers at the ECB, Francois Villeroy de Galhau, the Governor of the Bank of France, downplayed the necessity for significant rate cuts. Data released last Friday showed that the eurozone's private sector experienced growth in January after two months of contraction, surprising analysts In addition, Trump's policy shift has triggered frenzied speculation in recent weeks, causing significant fluctuations in the foreign exchange market. Since the November election last year, analysts have been predicting that the euro will reach parity with the dollar.

Over the past two weeks, the euro surged more than 3% due to bets that tariffs would be delayed or softened. On Tuesday, these gains were reversed after Trump vowed to impose tariffs "far higher" than 2.5%.

There are still many uncertainties in Europe. In France, the newly formed government is trying to pass a budget in a turbulent parliament, which is as difficult as walking a tightrope. In neighboring Germany, voters will go to the polls in February after Chancellor Olaf Scholz's coalition government collapsed in November.

A Bloomberg survey shows that the eurozone's fourth-quarter Gross Domestic Product (GDP) will also be released just hours before the European Central Bank policymakers announce their decision on Thursday, with the data expected to grow only 0.1%, down from 0.4% in the third quarter.

Nicolas Jullien, Global Head of Fixed Income at Candriam, stated that the European Central Bank's meeting in March will be "especially important, as the first actions of the U.S. government and the results of the German election will have been revealed."

However, Candriam holds an overall optimistic view on eurozone core government bonds, noting that the downward path of inflation in the eurozone is "more stable" compared to the U.S. The long-term inflation expectations indicator in the eurozone remains stable around 2%, in stark contrast to the corresponding indicator in the U.S. The Federal Reserve is expected to keep interest rates unchanged later on Wednesday.

Salman Ahmed, Global Head of Macro and Strategic Asset Allocation at Fidelity International, and others expect that the European Central Bank's rate cuts will exceed market expectations. He anticipates a total of 150 basis points this year, with the deposit rate reaching 1.5%, entering what many consider to be the realm of easing policies.

"This is the only way to protect oneself from tariff risks, allowing the European Central Bank to take more aggressive measures," Ahmed said. "What we question is not its direction, but its intensity."