ECB preview: One alone is like none at all. ECB preview: One alone is like none at all. ECB preview: One alone is like none at all.

ECB preview: One alone is like none at all.

Bonds
Althea Spinozzi

Head of Fixed Income Strategy

Summary:

  • The ECB is anticipated to deliver a 25bp rate cut at the June meeting, according to recent speeches by governing council members.
  • We expect the ECB to maintain a data-dependent approach to future policy rate changes, which could sustain rate market volatility and hinder the development of a bond bull market.
  • It may be still too early to increase duration exposure in fixed income. As the economy recovers and inflation remains above central banks' targets, the yield curve is likely to bear-steepen.
  • EUR OIS curve has shifted hawkish and market expects only two ECB rate cuts this year. This could mean more sensitivity for EUR in case President Lagarde signals more rate cuts. EURUSD could break below 1.0750 in that case. 

ECB policymakers have been gearing up for a potential interest rate cut at next week’s ECB meeting for weeks now. Although inflation hasn't yet hit the central bank’s 2% target, they seem to think there's an opportunity to slightly ease monetary policy while still maintaining overall restrictiveness. However, with persistent inflation in the US and geopolitical tensions driving up commodity prices, markets are keen to gauge just how much the ECB is willing to loosen its stance this year as markets remain wary of a policy mistake. Those fears are likely to force the ECB to keep a data-dependent approach going forward.

Macroeconomic projections unlikely to shift market expectations.

Since the start of the year, market expectations have adjusted significantly, removing 100 basis points (equivalent to four rate cuts). Currently, markets are predicting two and a half rate cuts by December, with the second cut expected in October. This is one less rate cut than what markets predicted just before the March ECB meeting.

More interesting is the observation that, while markets anticipate the ECB will continue cutting rates through September 2025, they don't foresee a return to pre-COVID monetary policies. Instead, they expect rates to bottom out around 2.75%. That’s a strike contrast to the negative interest policies the eurozone has been accustomed to from 2024 until today, implying that a much-anticipated bond bull rally in the long part of the yield curve might not materialize anytime soon.

The upcoming June staff projections aren't expected to significantly alter the monetary policy narrative. However, they might indicate a slight improvement in short-term growth and slightly higher near-term inflation forecasts. This adjustment follows the technical assumptions from the March meeting, which anticipated a constant exchange rate and a drop in oil prices to $75 per barrel.  Such forecasts confirm the point that interest rates are likely to remain above pre-COVID averages for longer.

ECB's victory lap doesn't mean inflation is a problem of the past.

Despite a significant drop from its 2022 peak, inflation remains elevated and well above the 2% target at both headline and core levels. With economic activity rebounding and persistent wage pressures at 4.7%, it's likely that inflation will stay above target throughout the year.

It's important to remember that since the COVID-19 pandemic, the US CPI has been a reliable leading indicator for euro-area inflation. Now, as the US shows signs of a possible rebound, it signals that the fight against inflation may not be over even in Europe. 

Source: Bloomberg and Saxo.

Still Too Early to Increase Duration Exposure

Unfortunately, it may still not be the time to invest in ultra-long maturities. The reason is straightforward: the economy is recovering while inflation remains above central banks' targets, preventing the ECB and others from aggressively cutting interest rates.

Currently, three-month Euribor future contracts reflect market expectations for the ECB to cut rates to 2.63% by September 2027. Although the spread between 10-year Bunds and the ECB deposit rate has been negative since 2022, 10-year Bunds have historically provided a pickup over the ECB deposit rate. As the yield curve normalizes, 10-year Bunds are expected to offer a yield above the ECB rate, establishing a floor around 2.63%, suggesting that 10-year Bunds may continue to rise towards 3%.

The outlook is even more bearish for longer European sovereigns. For instance, 30-year Bunds, currently trading at 2.79%, are expected to provide an increasing pickup over 10-year Bunds as the yield curve steepens. Historically, 30-year Bunds have paid an average of 57 basis points over 10-year Bunds since the mid-'90s, setting a floor around 3.2% for this tenor.

Therefore, we continue to favor the front part of the yield curve and remain cautious about duration as yield curve normalization occurs amid a strong economy and above-target inflation pressures.


FX: How Far Can the Divergence Trade Go?

EURUSD started the year around highs of 1.10, when both the Fed and the ECB were expected to cut rates by six times or so.

However, despite the pushback in easing expectations for both US and Eurozone, EURUSD is down to 1.08. This is because the ECB is taking the lead in easing policy this time around, and policymakers have been vocal about not waiting for the Fed to make the first move.

The path from here will depend on ECB comments out of the June meeting. The market is betting on a ‘hawkish cut’ given that policymakers are likely to take a data-dependent approach rather than pre-commit to further rate cuts. However, much of those hawkish signals are priced in the EUR OIS curve with the next move from the ECB only see in October. The Fed’s next move could be more critical for the ECB after the June meeting, as policy divergence is unlikely to go too far.

Let us consider the impact on EUR by considering different ECB meeting outcome scenarios:

  • If ECB remains data dependent
    • EURUSD could remain range-bound and dollar-dependent, trading between 1.0750-1.090
  • If ECB signals it will continue to remove restriction, or projects more than 2 rate cuts this year (market is pricing two ECB rate cuts in 2024)
    • EURUSD could break below 1.0750
    • EURGBP could break below 0.85
  • If ECB signals it will be slow to remove further restriction
    • EURUSD could rise back towards 1.0850
    • EURCHF and EURJPY could gain

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