• Euro tumbles as ECB raises rates but hints at pause

• US dollar hits 6-month high after US retail sales beat

• Stocks rally on upbeat Chinese data but watch out for triple witching

The European Central Bank raised its key lending rates by 25 basis points on Thursday, taking some investors by surprise amid a split within the Governing Council heading into the meeting. Markets and economists were certain policymakers were going to skip a hike in September. But the bets began to shift on Tuesday after ‘sources’ revealed that ECB staff will up their inflation forecasts, making a pause unlikely.

Thursday’s decision takes the deposit rate to 4.0% - the highest on record since the euro’s introduction in 1999, worsening the hardship for businesses and consumers just as falling inflation had started to offer some relief. But with energy prices creeping up again and core measures of inflation still elevated, the ECB’s actions shouldn’t have been totally unexpected.

The main worry is that whereas at the onset of the ECB’s tightening cycle the Eurozone economy was in much better shape and managed to ride out the energy storm, growth prospects have weakened considerably since and recession risks are rising again.

Even if a full-blown recession doesn’t materialize, stagflation seems like the most optimistic scenario for Europe right now and that’s why the euro’s knee-jerk spike higher as the announcement came in lasted only a few seconds. The ECB’s carefully worded statement implied that rates at current levels should be restrictive enough to bring inflation down to 2%, wiping out rate hike expectations while pushing up rate cut bets for the second half of 2024.

President Christine Lagarde wasn’t able to ease the euro’s pain much even as she stressed in her press briefing that rates have not necessarily peaked yet.

The euro closed 1.1% lower on Thursday after touching an intra-day trough of $1.0629. It’s trading about 20 pips higher today amid fresh reports in the Financial Times that the hawks would favour a rate hike in December if inflation and wage data remain hot.

However, from investors’ viewpoint, any further tightening would deepen the economic downturn, increasing the odds of steeper rate cuts later on. Hence, the euro’s modest reaction to the headlines.

Adding to the single currency’s woes yesterday was a fresh excuse to buy US dollars following somewhat stronger-than-expected retail sales and producer price data. Retail sales in the US grew 0.6% month-on-month in August, handily beating forecasts of 0.2%. However, the increase was mainly driven by higher gasoline prices and July’s reading was revised lower. What pushed up the dollar more was the jump in the producer price index, as the yearly rate accelerated for the second straight month to 1.6% in August.

Rate hike odds didn’t move much, but expectations for rate cuts were slightly scaled back, lifting the dollar index to a six-month high.

The greenback is slightly softer today following some encouraging economic indicators out of China.

Both industrial production and retail sales rose more than forecast in August, adding to hopes that Chinese authorities’ efforts to boost the economy are starting to have some effect.

The People’s Bank of China cut the reserve requirement ratio by 25 basis points for all banks on Thursday, while earlier today, it further boosted liquidity through reverse repurchase operations, cutting the 14-day reverse repo rate by 20 basis points.

The Australian dollar edged up to near two-week highs and regional stocks rallied, with the exception of the local stock market, which closed lower.

The upbeat mood carried over to European markets, though US futures were mixed after solid gains on Thursday.

Wall Street is headed for a positive close for the week despite the strong possibility that the Fed may have to hike again even if it pauses next week. In the meantime, there is a risk for some volatility on Friday as it’s triple witching day when stock options, stock index options and stock index futures all expire on the same day for the month and quarter.

Commodities were also buoyed by the improving economic picture in China. Oil futures climbed to fresh 2023 highs, with WTI futures hitting $91.15 a barrel and gold rose for a second day. The slightly weaker dollar today and the ECB’s pause signal yesterday are likely helping the precious metal to claw back some losses even as US yields are edging up today.