Currently, the market is pricing a 75% chance of a hike in July and a 41% chance in September. Wiping out chances for a hike in July means there might be an upside for short-term European sovereigns this week, particularly for 2-year government bonds, which sentiment is tightly linked to monetary policies. However, a revision of the ECB staff projections will dictate whether such a rally will be short-lived as the central bank needs to consider weaker growth and sticky core inflation.
In March, the ECB macroeconomic staff projections showed the economy recovering quickly, with growth matching the pre-pandemic yearly rate of 1.6% in 2024. The same forecasts showed inflation to remain above the 2% target until 2025.
The picture of a growing economy able to decelerate inflation doesn’t resonate with economists. That’s why it’s likely that at this meeting, the ECB macroeconomic forecasts might entertain a gloomier economic outlook. The gloomier the ECB’s macroeconomic forecasts, the more dovish the market expects the ECB to be in the future, driving long-term yields lower. However, if the projections are not as gloomy, the “higher for longer” message will better resonate with investors, and front-end yields still have a chance to rise.
How will markets react if the ECB communicates a hike pause in July?
Since the end of May, the 2-year German swap spread dropped sensibly. The move has been caused by quickly rising 2-year Schatz yields. A drop in yields might erase June’s downward move in swap spread. That will bring us back to square one: if inflation is sticky, the ECB needs to do more to fight it; hence front-end sovereigns will remain under pressure in the upcoming months.