Euro Pares Gains against the Pound as ECB's Knot Draws Doubts Over September Rate Hike

Above: ECB Board Member and Head of the Dutch central bank, Klaas Knot. Image © ECB.

The Euro to Pound exchange rate pared its recent advance to0.8585 after a prominent member of the European Central Bank's policy-setting committee raised doubts on the prospect of a September interest rate hike, potentially casting a softer outlook for Euro exchange rates.

Dutch central bank governor Klass Knot - who is a member of the ECB's Governing Council - said it looks as though Eurozone core inflation has plateaued and he is optimistic inflation will fall back to the 2.0% target in 2024.

The Euro remains one of the better-performing currencies of the past week and month, but the prospect of this outperformance extending over the coming weeks and months will depend on what the European Central Bank does.

Markets see a 70% chance of a rate hike in September, therefore a great deal of repricing lower is available, which can weigh on the Euro.

Knot - who has proven one of the more 'hawkish' members of the ECB this cycle - said the ECB will have to raise interest rates in June, but he said a balance needs to be struck to avoid overtightening.

He concedes that a lot more data is still to come and that hikes "beyond July" are possible, but not certain.

"For July I think it is a necessity, for anything beyond July it would at most be a possibility but by no means a certainty," Knot told Bloomberg TV. "From July onward I think we have to carefully watch what the data tells us on the distribution of risks surrounding the baseline."

That one of the ECB's known hawks is now cooling expectations for anything beyond another 25 basis point hike marks a significant point in the current cycle in that it provides a clear signal that the peak is now in sight.

"Interesting to see that even the most hawkish members aren't pushing for a September hike for now," says Christophe Barraud, Chief Economist and Strategist at Market Securities.

The Euro's recovery against the Dollar and resilience against Pound Sterling in 2023 is linked to the ECB's rapid interest rate increases that have lifted the yield paid on Eurozone bonds.

This has prompted Eurozone investors to repatriate external investments as local assets offer greater yield, boosting the Euro in the process. It has also prompted international investors to send capital into the Eurozone to take advantage of improving rates.

But this trade has depended on a 'hawkish' ECB outlook and any indication the central bank is shifting its stance could compromise these Euro-supportive dynamics, and at the very least, can put a lid on outperformance.

To be sure, the impact on the Euro of Knot's comments hasn't been substantial but they come in the context of a recent run of outperformance, particularly against the Dollar, becoming stretched. Euro-Pound had been as high as 0.8607 on Tuesday morning but is back at 0.8583, the Euro-Dollar had reached a new 2023 high at 1.1275 and has retreated to 1.1250.