Market Analysis

Expectations of an ECB rate cut Before Making a Move, Begin to Unravel

Amos Simanungkalit · 04 Jun 20242.6K Views

Certain analysts and investors are beginning to reevaluate their expectations for interest rate reduction this year due to strong economic statistics and strident hawks from the European Central Bank.

After this week's initial step, most analysts still predict quarterly reductions; but, some believe that monetary relaxation will be constrained by sticky inflation, rapid wage growth, and surprisingly strong output in the eurozone.

Additionally, traders have reduced their bets, as seen by Executive Board member Isabel Schnabel and Bundesbank President Joachim Nagel appearing to rule out July and Austria's Robert Holzmann suggesting that two reductions in 2024 could be sufficient.

Officials with caution worry that if borrowing costs are lowered at successive sessions, markets may adopt that pace as the norm. They might also be less optimistic than some of their peers that the Federal Reserve's policy, which is probably going to remain unchanged for some time, can actually be legitimately deviated from by the ECB.

According to Scope Ratings analyst Dennis Shen, "we've been comparatively hawkish with our expectations since last year of only three 25-basis-point cuts for this year, but the risk for these expectations remains decidedly for fewer rate cuts — not more." "It makes sense that the ECB would want to avoid making the error of cutting too aggressively in this final mile."

The most recent economic statistics provide reason for caution. It may take longer for price pressures to subside, especially in the services sector, as evidenced by the failure of a crucial euro-zone pay indicator that officials had believed would demonstrate that inflation had finally been defeated. In fact, inflation increased more than predicted last month, rising to 2.6% from 2.4% in April.

Simultaneously, the 20-country economy recovered more forcefully than expected from the mild recession it experienced in the second half of last year, with the labor market remaining strong, unemployment having recently reached a record low, and business surveys even indicating signs of life at faltering manufacturers.

The June cut, which would lower the deposit rate from the record 4% it attained nine months ago, is seen by no one as a policymaker retreating. Additionally, in the upcoming months, the general retreat in consumer price growth should continue.

However, analysts predict fewer transactions this year. Prior to the ECB meeting in April, nearly half of participants in a Bloomberg survey predicted four or five rate decreases in 2024. No one forecasts five anymore, and the percentage of people who see four has decreased.

In a same vein, markets, which as recently as April priced in three reductions for this year, have now ruled out July and only placed a 60% possibility on a September step.

According to Gabriele Foa, a portfolio manager at Algebris Investments, "we believe the ECB will revise their quarterly inflation projections higher, creating an awkward backdrop for the cut," in an email. The markets now only envision about two cuts by year's end, having virtually completely ruled out a cut in July. As things stand, we think this week's ECB cut could eventually be seen as a policy error.

According to a recent Bloomberg survey, economists Piet Christiansen of Danske Bank and Mariano Valderrama of Intermoney in Madrid are among those who don't see a second decline until as late as December.

Valderrama stated, "We have concerns about September," pointing to the labor market, earnings, and quicker economic growth. Furthermore, "this year's fiscal policy isn't going to become much less restrictive."

Others, such as Bayerische Landesbank's Gebhard Stadler, forecast a halt in the last month of the year following just two cuts.

Given ongoing robust wage growth and solid margin trends, he predicted that core inflation would prove to be more tenacious than the ECB had previously predicted. "Moreover, there is a great deal of uncertainty surrounding trade policy and the euro-dollar exchange rate as a result of the US elections."

There are concerns about how far ahead the ECB can go on its own given the Fed's indication that US rates could need to remain high for longer in order to guarantee inflation returns to 2%. Despite beginning earlier, ECB President Christine Lagarde and her colleagues stress that they are taking their time bringing down borrowing costs.

Policy will continue to be restrictive through 2024, according to Chief Economist Philip Lane, who promised to take his inspiration from the data as it becomes available. Even while they are adamant about approaching each meeting individually, a few other officials have given some really harsh advice.

Schnabel argues against a second cut in July due to concerns about premature policy easing, while Nagel stated that the ECB will "have to wait till maybe September" to make another reduction "if" it delivers in June. Holzmann emphasized that he won't support other cuts if they aren't warranted just because he is "ready to support one cut."

"In the past, rate reductions were always followed by additional rate reductions to support growth or address a crisis." stated Carsten Brzeski, Head of Macro at ING. But none of these two are present this time. Consequently, there's a good chance that the ECB will be obliged to switch from a "one is none" to a "one-and-done" position.