Market Analysis

On Thursday, traders reduced their expectations for consecutive rate cuts from the European Central Bank (ECB) through the remainder of the year. This shift followed policymakers' lack of clear signals on their commitment to further monetary easing.

Shortly after the ECB meeting, Reuters reported that another rate cut in October seemed unlikely unless there was a significant worsening of the economic outlook. Earlier, the bank had reduced its key deposit rate to 3.50%—its second cut in this cycle—while emphasizing that services inflation remained high. The ECB reiterated its stance of keeping rates sufficiently restrictive for as long as necessary.

ECB President Christine Lagarde emphasized that future rate decisions were not set in advance, indicating that the central bank would assess the situation at each meeting without making pre-commitments.

Following this, traders adjusted their expectations for a 25-basis-point rate cut in October, lowering the probability to around 20% from over 30% before the meeting. For the entire year, in addition to Thursday’s cut, they now anticipate a total reduction of 33 basis points, down from 36 bps earlier in the day.

“Lagarde achieved exactly what she intended—avoiding market disruption,” said Piet Christiansen, chief analyst at Danske Bank. “She seems content with the current market pricing of around 25 basis points per quarter.”

In response, Eurozone government bond yields surged as traders scaled back their rate cut expectations. Germany’s two-year bond yield, particularly sensitive to interest rate changes, saw a nearly 10 bps increase, marking its largest daily jump in almost a month. Meanwhile, the euro edged up 0.25% to $1.10393, and European stocks closed in positive territory.

Divergence Between the ECB and the Fed

With U.S. Federal Reserve rate cuts expected to begin next Wednesday, attention turned to how the ECB’s divergence from the Fed could influence the markets. Traders expect around 100 bps in rate cuts from the Fed this year, beginning with a 25 bps reduction, with a possible 50 bps cut at one of the upcoming meetings.

By the end of 2024, traders predict that the Fed will implement 10 rate cuts of 25 bps each, while the ECB will deliver six cuts. Analysts noted that currency fluctuations could significantly impact the ECB’s strategy, as a stronger euro might tighten financial conditions for the Eurozone’s sluggish economy.

An "aggressive" Fed move next week could raise the stakes for the ECB’s October meeting, said Christiansen. However, market expectations for a 50 bps Fed cut remain low at around 20%.

Despite expectations of fewer cuts from the ECB, analysts do not foresee significant gains for the euro. A recent Reuters poll projected the euro would rise modestly to $1.11 by February and $1.12 within a year, just shy of its August peak.

Those holding long positions on the euro would be banking on "a pro-growth environment where the rest of the world is outperforming the U.S.," according to James Athey, a fixed interest fund manager at Marlborough.

Some investors argued that Eurozone government bonds, which have underperformed U.S. Treasuries this summer, have more potential for a rally. "The safest part of the bond market is in Europe," said Mario Baronci, a multi-asset fund manager at Fidelity International. He added, "If you look at the U.S. yield curve, the market has priced in about 250 bps of cuts over a few years, which is quite substantial. I prefer to be in Europe."

The ECB recently downgraded its growth forecast for this year and next, citing weaker domestic demand, but still expects inflation to hit its 2% target by the second half of 2025. However, some investors worry that the ECB may be too slow to ease monetary policy, potentially hindering the region's economic recovery. Germany's economy, in particular, contracted in the second quarter.

"If the ECB is slow to cut rates, the economy may not get the stimulus it requires," said Seema Shah, chief global strategist at Principal Asset Management. "From a fundamental perspective, Europe is not as attractive for investors compared to other regions," added Shah, whose firm holds an underweight position in European equities.

Paraphrasing text from "Reuters" all rights reserved by the original author.