Amid increasing pressures from US tariffs and political instability in Europe, traders are beginning to bet on a more aggressive monetary policy shift from the European Central Bank (ECB). The prevailing sentiment in the market suggests that the euro may weaken considerably, potentially dropping below the parity level of 1 euro to 1 US dollarThis scenario is expected to be accompanied by a rise in bond prices as the ECB may loosen its rate policies in the upcoming months, with a consensus predicting a reduction of 25 basis points during the next meeting.

The overall market forecast anticipates at least three additional rate cuts by the ECB by the end of the year, bringing the deposit rate down to 2%. This potential shift highlights a significant divergence from the Federal Reserve's policies in the USHowever, some strategists warn that if punitive trade tariffs from the US become a reality, this gap between US and European monetary policies could widen more rapidly than expected.

The imposition of tariffs on imports from Europe could compel the ECB to further lower interest rates to bolster an economy that is already showing signs of stress

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Consequently, this move may adversely impact the euroMeanwhile, with the Federal Reserve maintaining its high-interest policies in response to the prospect of renewed inflation resulting from tariffs, the US dollar is likely to see increased support.

Tim Brooks, the head of forex options trading at Optiver, commented, “As soon as a tariff against Europe is announced, the exchange rate is expected to return to parity.” In the long term, market participants are proactively looking to hedge against the euro weakening versus the dollar, with investors bracing for the possibility of further declines below the parity threshold.

In the options market, the risk reversal—a key gauge reflecting the sentiment and positioning of traders—indicates that the cost of hedging against a weaker euro by the end of the year is nearing its highest level since JuneData from the US Depository Trust & Clearing Corporation highlights that the demand for options predicting the euro to reach parity or below has more than doubled in volume compared to November and December.

This cautious sentiment extends into the interest rate markets, where traders are betting heavily on options suggesting that the ECB will cut rates by at least 50 basis points before mid-year, marking an acceleration from the previously expected pace of 25 basis points

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One market participant has even purchased a strategy targeting a deposit rate of 2% by mid-year.

According to Konstantin Vitte, a portfolio manager at Pacific Investment Management Company, “We believe that the eurozone's economic growth will face increasing downside risks, and ultimately the rates may fall below current expectations.”

In terms of policy shifts, it’s important to note that not all ECB policymakers are ready to endorse drastic interest rate cutsFrançois Villeroy de Galhau, the Governor of the Banque de France and one of the ECB's more neutral voices, has downplayed the necessity for large aggressive cutsIn fact, data released last Friday indicated an unexpected increase in the eurozone's private sector following two months of contraction, which analysts found surprising.

Additionally, recent alterations in US policy have incited waves of speculation, causing significant volatility in the forex markets

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Since November, analysts have predicted that the euro could reach parity with the dollarOver the past fortnight, speculation surrounding the potential postponement or softening of tariffs saw the euro surge by over 3%. However, those gains were rapidly reversed following the announcement of comprehensive tariffs in the US that significantly exceed the previously reported threshold of 2.5%.

Many uncertainties linger within the eurozone itselfIn France, for instance, the new government attempts to navigate a tumultuous parliament to pass a budget amidst challenging circumstances.

According to a Bloomberg survey, GDP figures for the eurozone's fourth quarter will be revealed just hours before the ECB's forthcoming policy announcement on ThursdayThis data is anticipated to show a mere 0.1% growth, down from 0.4% in the previous quarter.

Despite the uncertain outlook, Candriam holds a generally optimistic view on core eurozone government bonds

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They maintain that the disinflationary trajectory in the eurozone is “far more robust” compared to that of the USLong-term inflation expectations in the eurozone appear stable around the 2% mark, in stark contrast to corresponding figures in the US, with expectations that the Federal Reserve will keep interest rates unchanged in its announcement later on Wednesday.

Salman Ahmed, Fidelity International’s Global Head of Macro and Strategic Asset Allocation, who possesses extensive expertise in finance, predicts a more aggressive course for ECB monetary policyAhmed posits that the ECB’s rate cuts will far exceed the current market expectationsWith the European economy grappling with a multitude of challenges—including sluggish growth, fluctuating inflation pressures, and escalating geopolitical tensions—he foresees that the ECB will enact aggressive rate cuts totaling 150 basis points over the year

If realized, this would lower the ECB's deposit rate to 1.5%, entering a zone considered accommodating by many analysts.

This kind of substantial rate cutting could bear significant ramifications not only for Europe but also on a global scaleInternally, a low-interest-rate environment could stimulate corporate investments and encourage consumer spending, thereby propelling economic growthOn a broader level, the ECB's aggressive rate cuts may trigger a chain reaction affecting the direction of international capital flows and influencing monetary policies and financial market stability in other nations.

Investors are also beginning to reassess their strategies in anticipation of possible market changes following Ahmed's predictions“This is essentially the only way to protect oneself against tariff risks—by pushing the ECB to adopt more aggressive measures,” Ahmed stated