Morgan Stanley's FX strategists comment that higher interest rates typically strengthen the currency, unless they reflect an excessively restrictive monetary policy that harms growth or raises concerns about the sustainability of public debt.
None of these circumstances seem to apply to the EUR at present, so they expect an interest rate hike by the ECB to have a positive effect on the European currency. Furthermore, although historically currencies can weaken when monetary policy enters restrictive territory, that effect tends to occur with a delay and after an initial phase of appreciation.
In the case of the EUR, the market still does not price in a level of monetary tightening by the ECB sufficient to harm the currency, as reflected by the German 1Y-5Y5Y spread of -78bp and short-term yields that remain below long-term nominal levels. In fact, in recent quarters the EUR has tended to appreciate in parallel with the increase in European yields, unlike what has been observed in the UK or Japan, where the rise in yields has been more linked to fiscal concerns.
The main risk for the EUR remains a possible financial fragmentation within the European periphery. A widening of the spreads between French (OAT) and German (Bund) bonds or between Italian (BTP) and German bonds would be a sign that the market is starting to incorporate greater fiscal risks within the Eurozone.