Key Highlights

• ECB to move EUR central tendency but inflation impact unclear
• Geopolitical risk compounds valuation challenges for CEE currencies
• Fed easing may no longer deter FX hedging for EM duration

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EURUSD continues to push through ECB’s anchoring assumptions

EXHIBIT #1: EURUSD PERFORMANCE VS. ECB PROJECTIONS

_{Source: BNY, Macrobond, ECB}

Our take

We remain very cautious on the EUR’s current valuations but acknowledge that tolerance from the ECB is probably higher than previously anticipated. President Lagarde will continue to emphasize the downside risks to growth and the associated price impact. However, the data have not deteriorated sharply and there is more certainty over the trade situation since the June forecast round, albeit with terms not exactly highly beneficial to the broader European Union. At best, the door to a cut in October will probably remain open, but we suspect Lagarde will face more questions on the situation in France than ECB policy, and whether contingencies are now in place to manage sovereign spreads to prevent sudden adverse tightening in financial conditions. Nonetheless, we believe there is a strong risk that she will use more forceful language on the euro as it is pushing against the upper limits of tolerance before the impact on inflation becomes significant.

Forward look

The ECB’s June projections included a sensitivity analysis on alternative exchange rate paths, highlighting downside risks to growth and inflation from potential euro appreciation. The baseline projection assumes a constant EURUSD rate of around 1.125, but alternative paths were derived from option-implied neutral densities as of May 14, 2025, which suggested scope for further euro strength. At the 25th percentile, the euro is projected at 1.09 through 2027, representing a 3.6% lower rate than the 2026 baseline, boosting real GDP growth by 0.1 percentage points in 2026–27 while increasing HICP inflation by 0.1 percentage points annually from 2026 onward. At the 75th percentile, the euro appreciates more significantly, reaching 1.25 in 2027 (a deviation of up to +11.2%), with GDP growth falling by 0.2–0.3 percentage points in 2026–27 and inflation lower by 0.2–0.3 percentage points and missing the inflation target, albeit only marginally. The current level of the EUR is clearly pushing well into the highest percentiles relative to previous forecast rounds (Exhibit #1) and bringing the negative impact forward. Unless pass-through and exchange rate transmission is broken, the ECB continues to see stronger euro paths consistently dampen growth and inflation, underscoring the exchange rate’s role as a key risk factor for the euro area outlook. At the very least, Lagarde will make this point more forcefully.

PLN the clear outlier in exchange rate performance

EXHIBIT #2: : PLN, HUF AND EUR REAL EFFECTIVE EXCHANGE RATES

_{Source: BNY, BIS}

Our take

Geopolitics has returned to the foreground this week, and moves in Polish equities were quite notable on Wednesday. We expect much of the knee-jerk moves to subside, but the scale of the adjustment has exposed the very high levels of positioning in Polish equities, and the associated valuations challenges. Even though PLN is now moderately underheld, mostly due to high levels of hedging flow around this year’s presidential election, there has not been any additional interest in even maintaining these hedges. Combined with the ongoing support in Polish equities (before the week’s events), allocations were likely too high heading into a more challenging macro environment. Furthermore, we can see that PLN’s real effective exchange rate has surged well above the EUR and peers such as HUF. While high REERs can reflect structural changes such as improved balance of payments, productivity and real incomes, inflation differentials are a core driver and will directly challenge corporate competitiveness, which also warrants hedging against equity risks.

Forward look

If there is wider conflagration, then it will be difficult for CEE currencies or assets sustain their current valuations, though PLN did manage to hold the line in H1 2022 despite the associated risks, while HUF was the clear underperformer at the time as effective real rates fell sharply, mostly due to fiscal policies. The NBP is now in a position to ease policy more forcefully as inflation slows and without much risk of supply pressures driving up prices unexpectedly. Current PLN valuations are clearly a restraining factor in the economy and more easing will likely be factored in. Even if the nominal remains soft, then inflation differentials may start to pressure the REER as well. As is the case with much of EM asset allocation at present, we are not averse to maintaining above-average holdings but FX needs to be used as a release valve amid rising idiosyncratic and market risk.

High yielders to become more sensitive to hedging interest

EXHIBIT #3: IDR APPROACHING UNDERHELD BUT MATCHES SUSTAINED BOND INTEREST

_{Source: BNY, Bloomberg}

Our take

Despite escalating domestic pressures across various South and Southeast Asian economies, there is no sign of extraordinary stress but we are seeing a steady reduction in IDR holdings, while the THB remains poorly held – as would be expected for most low-yielders which are relatively well-funded. IDR has shifted from the best-held carry name in APAC to flat. For a relatively high yielder, moving from neutral to outright underheld will be expensive and we note that selling interest has been limited over the past week as global scrutiny has intensified. While tactical positioning in response to events is a potential factor, we note that there is strong inverse alignment between currency and bond holdings (Exhibit #3), which suggests more nuanced asset allocation rather than outright liquidation. Indonesia’s bonds remain attractive on both an absolute and real yield basis, though our stance has shifted from positive to neutral over the past two weeks in light of recent domestic developments. We remain prepared to re-engage should conditions become more supportive, but we acknowledge that the rupiah faces potential pressures from external factors and fiscal deficit uncertainties.

Forward look

Narratives similar to Indonesia can be extended to most total return positions in emerging market debt, especially in Latin America and EMEA, where currency and bond holdings remain very strong. While concerns persist regarding historically imbalanced growth and widening deficits, these are counterbalanced by meaningful opportunities for economic expansion, which continue to underpin the medium-term appeal of emerging markets. Despite current institutional and trade challenges, which are pervasive globally, structural growth trends remain positive and high real rates and a commitment to fiscal prudence will continue to support duration. While commitments to currency stability are strong, managing volatility is preferable to the simple exchange rate targeting of the past. As the Fed’s easing cycle becomes clearer and dollar valuations trough, we expect renewed scaling up of FX hedges and traditionally overheld carry currencies will be the first in line for exposure reduction, irrespective of yield differentials.

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