ECB preview: holding the fort at all costs.

This week's European Central Bank monetary policy meeting will be a focus for markets together with the FOMC and Bank of England.

Bond futures are pricing a 50% chance that the ECB will begin cutting rates in March next year, delivering overall five rate cuts throughout 2024. That means the ECB is expected to move towards rate cuts before the Fed and the BOE. This notion is reinforced by three consecutive months of inflation figures that are surprising on the downside, falling to 2.4% YoY, the lowest in more than two years. On top of it, the eurozone economy has slowed significantly, with Germany and the Netherlands in a recession.

We have heard several ECB officials turning slightly dovish for a few weeks, citing the need to cut interest rates next year to avoid further economic damage. The most recent change of heart comes from a prominent hawk: Isabel Schnabel, who, until last month, insisted that rate hikes need to continue to be an option. In a recent speech, Schnabel recognized that further rate hikes are unlikely and opened the door to rate cuts in the mid of 2024.

The ECB’s staff projections are in focus.

Although Lagarde will maintain a hawkish bias, updates to the ECB's staff projections might speak louder. As of September, these projections forecasted headline inflation to fall to 3.2% this year and 2.1% in 2024, while real GDP was to end 2023 at 0.7% and 2024 at 1%. As both GDP and inflation have so far surprised on the downside, it’s safe to expect a lower revision for both data this year and the next. The lower the projections, the more markets will anticipate aggressive interest rate cuts.

The ECB still has reasons to keep a hawkish bias.

A tight labor market will remain concerning for the ECB when looking at inflationary pressures in the eurozone. Unemployment remains at 6.5%, the lowest on record. Despite wage pressures starting to ease, they remain above 5% (compensation per employee), too high to ensure a return to the ECB inflation target of 2%. That’s why policymakers might not be rushing to dovish rhetoric this week and will instead want to stay on hold for longer, putting under scrutiny next year's rate cuts currently priced markets.

It’s also essential to remember that whatever happens in the U.S. will also be relevant for monetary policy decisions in the old continent going forward. An even stronger labor market in the U.S. suggests that the upcoming Fed’s aggressive rate cuts are unlikely. If expectations of rate cuts in the U.S. are pushed out to 2025, we can expect rate cuts to be pushed further into the future in the old continent as well. If the ECB cuts rates too early, it risks a sharp devaluation of the euro currency, risking to increase inflation.

Therefore, Lagarde is more likely to push back on early rate cuts rather than tilting dovish. Reinvestments under PEPP (Pandemic Emergency Purchase Portfolio), which were expected to remain untouched until the end of 2024, might be used to reject the idea that a cutting cycle is approaching. A couple of weeks ago, Lagarde mentioned that the PEPP program would need to be re-examined in the “not too distant future."

The PEPP facility will be in focus.

The PEPP facility has proven to be a valuable tool for the central bank because it enables it to skew bond purchases towards government bonds of those countries in which sovereign spreads are widening excessively compared to Bunds. Therefore, if PEPP is discussed at this meeting, it will not only provide a floor in terms of how early pre-emptive interest rate cuts may come, but it might also come as a blow to the periphery.

Suppose policies to end reinvestment under the PEPP are implemented as early as January 2024. In that case, a pre-emptive cut is unlikely to happen at the next monetary policy meeting in March. That should be enough for markets to push the probability of the first rate cut to April or June.

Yet, we believe that the BTP-Bund spread remains a critical measure for ECB monetary policies. It tightened significantly in the past couple of months, falling to 180 basis points from 206 basis points in October. Together with the fact that according to the Bloomberg Economics euro financial conditions index, economic conditions have eased to levels seen before summer, it remains improbable that the ECB will feel the urge to cut rates anytime soon. Its concern would rather be how to continue to maintain a hawkish bias without markets' front-running rate cuts, as happened in November. As the BTP-Bund spread widens above 200bps and heads towards 250bps, that would be a sign that the central bank becomes more uncomfortable about tight monetary policies and that easing might be approaching.