Analysis: Traders Expect ECB to Be First Major Central Bank to Cut Rates, According to Reuters

By Yoruk Bahceli

Financial markets are increasingly anticipating interest rate cuts from the European Central Bank (ECB), expecting it to be the first major central bank to loosen policy in response to a euro zone economy that is teetering on the brink of recession, especially when compared to the robust performance of the United States.

Last week, traders in money markets forecasted that the ECB, alongside the U.S. Federal Reserve and the Bank of England (BoE), would initiate easing measures in the latter half of 2024 as inflation rates decline and the impact of recent rate hikes begins to slow down economic growth.

However, this outlook shifted dramatically on Tuesday when new data revealed that euro zone inflation fell more than anticipated to its lowest level in over two years in October, coinciding with an economic contraction in the third quarter that raised the likelihood of a recession by year-end.

With investor confidence growing that major central banks are finished raising rates, attention has shifted to the timing of any potential rate cuts. Traders are now assigning an over 80% probability to a 25 basis-point cut by the ECB by April, a significant change from the previous expectation of a July cut.

Moreover, expectations for further cuts next year have also risen, with traders pricing in more than a 50% chance of four additional 25 basis-point reductions by the end of 2024, which would bring the key deposit rate down to 3%.

Shamik Dhar, chief economist at BNY Mellon Investment Management, remarked, "The European economy is clearly weakening and at a sharp pace." He added, "There are more reasons to believe rates have peaked in Europe than in the U.S. and the UK," a sentiment that appears to be shared by the markets.

In the UK, where the BoE maintained its rates on Thursday and dismissed the prospect of cuts in the near future, traders have increased their bets on eventual easing. They now foresee two cuts in 2024. However, with inflation remaining persistent, the BoE is expected to adopt a more cautious approach than its peers.

In contrast, the U.S. economy continues to demonstrate resilience, growing nearly 5% in the third quarter and defying recession predictions. As a result, expectations for rate cuts from the Fed have also surged, with traders pricing in the likelihood of four cuts next year, likely commencing in May, following weaker-than-anticipated job data. Still, they predict at least one fewer cut than they anticipated back in late July.

This divergence reflects the challenges posed by higher U.S. rates, contributing to a recent tumult in the global bond market. ECB President Christine Lagarde acknowledged last week that rising U.S. Treasury yields have influenced financing conditions in the euro area, especially as the ECB paused rate hikes for the first time since July 2022.

Despite shifting expectations, some investors, having been surprised by the hawkish stances of central banks in the past, caution that current market sentiments may be overly optimistic, potentially leading to another bond market sell-off. Expectations of a cessation in global policy tightening have led to a decline in bond yields from multi-year highs. In the euro zone, Italian bond yields were poised for their most significant weekly decrease since June.

Piet Christiansen, chief analyst at Danske Bank, noted that the current expectations for ECB rate cuts reflect a "doom and gloom" perspective, suggesting that only a drastic collapse of the European economy would warrant such forecasts.

Lagarde indicated it was too early to discuss rate cuts, while some hawkish policymakers labeled the bets on cuts in the first half of 2024 as "entirely misplaced." The ECB continues to underscore that wage growth remains strong, and services inflation persists. Additionally, geopolitical tensions, such as the ongoing conflict between Hamas and Israel, present further risks to the euro zone, particularly given its heavy reliance on energy imports, rendering it more susceptible to rising oil prices.

Gurpreet Gill, a strategist at Goldman Sachs Asset Management, expressed skepticism about current expectations and stated, "We’re underweight European rates on a cross-market basis. We still think the market is pricing too much ECB easing for next year," predicting that the first rate cut would occur next September.

Others have argued that the rising expectations for rate cuts serve as a warning to the ECB, suggesting that it has raised rates excessively in response to inflation primarily driven by energy costs, rather than domestic demand. Dario Perkins, managing director at TS Lombard, commented, "I don’t think Europe can sustain the current level of interest rates, so the ECB has likely gone too far. They need to correct course quickly." He also emphasized that the ECB would need to cut rates at least to the extent currently anticipated by traders in the coming year.