Lagarde to 'keep door open' for Sept hike, Euro to take hit

EUR/USD continues to find some support above the 1.14 level, though with the Iran war continuing to drag on and oil prices trending higher we could see a modest retracement in the near-term.

Focus tomorrow shifts decisively to the July meeting of the European Central Bank.

After raising rates in June, the Governing Council is almost certain to stand pat this week, but the latest surge in geopolitical instability has created a fresh headache for officials.

The key will be whether Lagarde confirms expectations for a second hike in September or if she leaves the door open to further tightening beyond that.

At the time of writing, swap markets are pricing in almost two full 25 basis point hikes during the rest of the year, an upward shift in rate expectations that we contend has been overly aggressive. Growth is weak, wage pressures are cooling, long-term inflation expectations are anchored and there are no signs of second-round inflation effects in the data.

In our view, the ECB risks compounding a policy error by tightening into what is, at its core, a supply-side energy shock rather than genuine demand-driven inflation. With this in mind, we expect Lagarde to keep the door open to a hike in September, but we do not believe that she will firmly signal one either, which could disappoint markets and weigh on the common currency.