Annalisa Piazza, Fixed Income Research Analyst at MFS IM
The ECB is expected to cut rates by 25 basis points at this week’s meeting. This cut has been widely anticipated since the April Governing Council meeting, although the ECB has consistently emphasized that decisions depend on data.
A June cut is widely discounted, but the outlook for the second half of the year is less clear, with less than a 100% probability that the ECB will cut by another 50 basis points (which is our base scenario). We do not expect the ECB to provide strong forward guidance during this week’s meeting, but the new updated projections will determine whether the recent data volatility has led to a significant change in the ECB’s policy outlook.
We expect the ECB, after examining the recent data volatility and updated projections, to confirm that inflation will return to 2% by mid-2025. Regarding growth, we struggle to see how GDP can be revised above potential levels in the short term, as the first quarter’s positive surprise is unlikely to repeat, given that the recent surge in energy prices could pose a minor drag on real disposable income in the short term and an obstacle to a robust investment recovery. We suspect that the GDP outlook for 2024 will remain relatively sluggish, with a recovery expected only in 2025 towards the baseline value.
June’s ECB projections will be closely watched. If the short-term inflation profile does not change substantially (despite rising negotiated wages), this would imply that the ECB is confident that the disinflation process is underway and that further cuts can be made in the second half of the year. With inflation falling to around 2% by 2025, it will be difficult to justify such restrictive policy rates. The ECB will need to be cautious in its communication to avoid speculation about policy rates moving into expansionary territory too soon. Currently, the risk is very low, as markets expect terminal rates above 2.5% within three years.
We expect Lagarde to confirm that the ECB is not influenced by the Fed and remains data-dependent. The possibility of a July cut will not be completely ruled out (as recently suggested by Villeroy), but there will be no announcements on this aspect.
Tomasz Wieladek, Chief European Economist at T. Rowe Price
This week, the ECB will cut the benchmark rate. This outcome has long been indicated by ECB policymakers, including some of the more hawkish members of the Governing Council. Recent data could have cast doubt on this development, but the forward guidance provided by the ECB is too strong to deviate from now.
Recent data has exceeded the ECB’s and markets’ expectations regarding inflationary pressures. Negotiated wage growth rose to 4.7% in the first quarter of 2024 from 4.5% in the fourth quarter of 2023, against expectations of a decline. In the latest European Commission survey, the percentage of firms citing labor shortages as a production constraint has increased again. This data strongly predicts negotiated wage growth, the ECB’s key wage indicator. Similarly, Eurozone HICP inflation in May was significantly stronger than expected, while services inflation rose from 3.7% in April to 4.1% in May. This is not just a base effect: seasonally adjusted and on a daily basis, services inflation rose by 0.5% in May. This is about double the rate required by the ECB to reach its target. Surveys suggest services inflation will eventually decrease, but this has yet to be seen in the actual inflation data. Finally, shipping costs from China are again rising rapidly, likely pushing up core goods inflation as well. Gas prices have also started to rise again. After a long period of disinflation, inflationary pressures across components are rising.
These inflation developments cast doubt on future cuts. Based on forward-looking wage and inflation indicators, I expect further disinflation in the second half of 2024. This would allow the ECB to make a total of three cuts this year. However, the risk that the ECB will cut rates only twice this year is increasing.
Shaan Raithatha, Senior Investment Strategist at Vanguard
The beginning of the ECB’s easing cycle at Thursday’s meeting has been widely anticipated by the Governing Council in recent weeks. A 25 basis points cut is expected for all three main policy rates: the deposit rate, the marginal lending rate, and the main refinancing rate. At the time of writing, markets have fully priced in this outcome.
The pace of subsequent easing, however, is more uncertain. May’s CPI surprised to the upside, driven by services, while prices for food, energy, and essentials remained stable. Even though we are still awaiting the exact data, it seems unlikely that base effects related to the Easter period and the introduction of the low-cost public transport ticket in Germany last year can explain the entire upside surprise. The increase in core services inflation, combined with wage and GDP growth in the first quarter, increases the risk that the ECB will cut rates at a slower pace than the currently expected quarterly cadence.
That said, we maintain our forecast of successive quarterly cuts for three reasons. First, high-frequency indicators suggest significant wage growth deceleration in the coming months. This is evidenced by the ECB’s and Indeed’s wage trackers and is an opinion shared by key Governing Council members, including Philip Lane (see his recent interview with the FT). This, along with recent signs of price moderation in European Commission surveys and PMI indexes, suggests that services inflation should soon start to decline. Second, given the considerable decline in inflation in recent months, the ECB can justify a lower nominal policy rate while maintaining the same level of real restrictive measures. Third, even the so-called hawks on the committee signal the expectation of multiple rate cuts this year. For example, Dutch Governor Klaas Knot has indicated that three or four cuts in 2024 would be consistent with the optimal policy based on the March projections, while Austrian Governor Holzmann has supported a rate cut on Thursday and expects a total of two or three cuts by December.
If this forecast is confirmed, our (and the ECB’s) assessment is that quarterly 25 basis points cuts would bring the central bank deposit rate to the neutral level (2-2.5%) by the end of 2025.
Patrick Barbe, Head of European Investment Grade Fixed Income at Neuberger Berman
May saw the first rebound in core inflation since March 2023, but only a return to levels from two months ago. The reason for this 0.2% increase is mainly due to temporary factors in the services sector, such as all-inclusive vacation packages in Germany and the end of discounts on service prices (VAT on electricity, train tickets,…), so this does not challenge the continuation of the inflation decline and hence the medium-to-long-term forecasts made by the ECB. Moreover, we must remember that out-of-control inflation led the ECB to raise the reference rate to 4% last year. Today, the question remains how long it will take for inflation to return to 2%, meaning a reference rate of 4% is somewhat too restrictive by Eurozone standards, increasing the likelihood of a first cut on Thursday.
We can expect a return to the downward trend in core inflation after May’s rebound. However, as the ECB has repeatedly explained, wage growth is the most relevant criterion for its future rate policy. First-quarter data saw a further increase of +4.7% year-on-year, well above the 3% threshold, driven mainly by Germany. This is clearly a problem, but new leading indicators point to lower negotiated wage increases, meaning the ECB can start cutting its reference rates but should remain cautiously data-dependent. We therefore expect the ECB to maintain its hawkish policy this year, but to a lesser extent, with the reference rate reduced to 3%. We foresee an outperformance of Euro bonds, with a 10-year Bund yield below 2.25%. While we expect the ECB to highlight uncertainties for the coming months, we await an updated analysis and its forecasts on national wage increases and their impact on the inflation rate.
Gilles Moëc, AXA Group Chief Economist and Head of AXA IM Research
It is very likely that the ECB will announce a rate cut on Thursday, even though recent data has not been helpful. In our view, central banks should wait for all indicators to align before changing course only in very specific cases: when long-term inflation expectations are unanchored, when monetary policy transmission is compromised, when monetary policy is countered by fiscal policy, and finally, when there are significant indications that the neutral rate has shifted higher. We believe that none of these conditions currently apply to the Eurozone.
Given the confidence that monetary policy is restrictive and will remain so even after a first 25 basis points cut, we believe the ECB could easily risk outlining its trajectory for the rest of 2024. However, we do not believe it will do so. We expect few indications from Thursday’s meeting, especially as opinions within the Governing Council remain too far apart to build a consensus at this stage. We expect the ECB to proceed with rate cuts in September and December. Such a pace would be justified by some pockets of resistance to disinflation in the services sector and the risk that corporate margin behavior will slow convergence towards the ECB’s target.
Such “margin resilience” could, however, materialize only if decent cyclical conditions prevail. Business confidence indicators have been more favorable for the Euro area recently, but we believe that the balance of risks remains tilted to the downside and that the Governing Council should be ready to remove restrictions more quickly. Data dependency should go both ways.
Conversely, in the United States, conditions are in place to wait for an almost perfect alignment of indicators, which makes the Fed’s reluctance to discuss a timeline for a policy shift perfectly understandable. However, we believe that the data flow is beginning to align, such as with further signs of weakening consumer spending. In this regard, this week’s labor market data will obviously be crucial, pending the data on new jobs and wages.
Franck Dixmier, Global CIO Fixed Income at Allianz Global Investors
President Christine Lagarde and the more dovish members of the Governing Council have strongly suggested the imminent cut, which has therefore been fully anticipated by the markets.
Investors’ focus will turn to what comes next. The start of a rate-cutting cycle, after a long phase of steady rates, will raise questions about the next moves. What is the target for the final rate? And how quickly will the ECB reach it? Investors will pay close attention to any hints in response to these questions, as well as to the macroeconomic forecasts expected to be presented.
While there is consensus on this first rate cut, the pace of future cuts is already the subject of lively debate within the Council. Inflation expectations are anchored at levels close to the ECB’s target (the 5-year inflation swap was 2.3%), providing a good indication of investors’ confidence in the central bank’s ability to meet its mandate. The Council’s focus will be more on the exact trajectory of inflation towards the central bank’s price stability target and its confidence level that inflation will remain at that level.
After peaking at +10.6% year-on-year in October 2022, the consumer price index in the Euro area stood at +2.6% in May 2024. The same downward trend is seen in core inflation: after peaking at +5.7% in March 2023, it fell to +2.9% last May. Although the decline in inflation recently has been notable, the ECB should continue to remain vigilant about potential second-round effects following wage increases (negotiated wages rose by +4.7% in the Euro area in the first quarter), as well as the trends in other costs, such as shipping, which has been impacted by the crisis in the Red Sea.
Future inflation data is likely to be volatile and the ECB might reiterate its gradual approach to rate cuts.
Lowie Debou, Fixed Income Manager, DPAM
The economic data, expectations, and communications received suggest that a 25-basis point cut by the European Central Bank is a certainty. However, we do not believe this will be sufficient to revive the fortunes of the continental economy. Such a modest cut would still keep monetary policy decidedly restrictive. At best, even a return to the pre-Covid neutral rate would require a greater cut. Even then, it is uncertain that we would witness a European growth trend similar to that of the United States, as this would require a rate policy well below neutrality.
It is very reasonable for the ECB to begin a full cycle of cuts before the Fed. In recent months, the likelihood that Frankfurt will manage to ensure a soft landing has increased significantly. Consequently, maintaining a too restrictive rate for too long increases the likelihood of a recessionary drift. If the ECB were to start cutting rates now, it could act more conservatively compared to previous cycles, maintaining the narrative of a soft landing. As a result, we would finally find ourselves again in a context where the ECB, if necessary, would have room to cut interest rates more aggressively, reducing the need for unconventional monetary policy. This would be an even better scenario for European fixed income investors, as yields would remain higher and carry-related returns would remain a reliable source of expected gains.
Azad Zangana, Senior European Economist & Strategist, Schroders
As for the European Central Bank, our estimates foresee the first cut occurring during the June meeting, followed by three more 25-basis point cuts by the end of the year.
We expect the ECB to make another two 25-basis point cuts in the first quarter of next year, then remain on hold for the rest of 2025. The pause will likely be forced by the reemergence of inflationary pressures. With the resumption of domestic demand and the return of growth above the trend, the lack of unused productive capacity, particularly in labor markets, should drive up wage inflation, forcing companies to raise the prices of their products. Although the Eurozone is emerging from a cyclical contraction phase, unemployment rates have remained close to decade lows, highlighting the impact of demographic aging and labor hoarding.
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Source: Economy - investing.com
