ECB Preview: Conflicting Narratives – Rate Cuts vs. Data Dependency

Summary:

• Rate Cut Probabilities and ECB Stance: Markets are assigning no chance of a rate cut this week, with bond futures indicating only a 4% probability. However, there is an 81% chance of a rate cut in September, and markets project a policy rate of 2.75% by 2026. Despite these expectations, we anticipate the ECB will remain data-driven, making even a September rate cut unlikely given the rebound in economic activity and potential upward revisions to the ECB’s inflation forecasts due to high oil prices.
• Final June CPI Data: The final June CPI data on Wednesday is expected to show minimal improvement on the inflation front. Headline inflation is projected to remain steady at 2.5%, while core inflation is anticipated to stay at 2.9%, slightly above the June projections. This indicates persistent inflationary pressures, particularly from the robust labor market and strong wage growth.
• ECB Member Dissent: Dissent among ECB policymakers was evident in the minutes of the May meeting, where disagreements over the rate-cutting cycle were highlighted. The upcoming meeting will be crucial to understanding what conditions might warrant another rate cut, especially given the rebounding economy and sticky inflation. This will help gauge the ECB's future policy direction amidst the current economic uncertainties.
• French Political Turmoil in Focus: French political turmoil may sway the decision for upcoming rate cuts. Extreme volatility in the European sovereign space could conflict with continuous quantitative tightening, as disinvestments under the PEPP have started this month. If European sovereign spreads become increasingly more volatile, policymakers might opt for a rate cut in Septemberdespite the economy and inflation remaining underpinned.

Overview

At the upcoming European Central Bank (ECB) monetary policy meeting, markets are not anticipating an interest rate cut, with bond futures indicating only a 4% probability of such a move. Nonetheless, markets are assigning 81% chance of a rate cut in September and projecting a policy rate of 2.75% by 2026.

As the minutes of the ECB’s June meeting revealed dissenting views among policymakers regarding the rate-cutting cycle, the upcoming meeting will be crucial for markets to gauge the timing of the next cut, considering the ECB's data-dependent approach. While progress has been made in addressing inflation, core inflation appears to have stabilized near 3%. Additionally, uncertainties persist around the euro area's growth outlook, amid a rebound in the bloc’s economy and sustained elevated wage growth.

Background

In June, the ECB implemented a rate cut despite internal disagreements. Some policymakers argued that data from early 2024 had not bolstered confidence in inflation returning to target, instead highlighting increased uncertainty. In the July meeting, this uncertainty extends to both inflation trajectories and forthcoming growth figures. While the Q2 2024 composite PMI showed improvement over Q1, the decline in June's PMI raises concerns about the sustainability of the Eurozone’s growth. That comes at odds with the ECB’s projections of real growth to remain at 0.4% quarterly for the rest of the year, followed by a decline in Q1 2025.

Inflation

Persistent services inflation, a robust labor market, and strong wage growth suggest that the ECB may not need as many rate cuts as previously anticipated. Headline inflation aligns with the ECB staff's June projections, averaging 2.5% for Q2. However, core inflation slightly exceeded the projected 2.7% in June, with preliminary data showing a rise to 2.9%. The upcoming final inflation prints on Wednesday, July 17th, are expected to show headline inflation steady at 2.5% and core inflation at 2.9%, indicating minimal progress.

Labor Market

Unemployment remains at a record low of 6.4% as of May, and services inflation continues to pose a significant risk to the inflation outlook. According to the latest Indeed Wage Tracker, annual wage growth in total euro-area compensation per employee reached 5% in Q2, up from 4.9% in Q1. Although this figure is below the post-pandemic peak of 5.5% last year, it is likely to remain elevated throughout 2024.

Data dependency and French political turmoil cast uncertainty on a potential rate cut in September.

The ECB’s data-dependent stance suggests that a rate cut in September is unlikely. With economic activity rebounding in the latter half of the year, the ECB has little justification for easing financing conditions. This is particularly relevant given the possibility of upward revisions to the central bank’s inflation forecasts in September due to persistently high oil prices.

Even though a rate cut in September appears unnecessary from a macroeconomic standpoint, sustained volatility in European sovereign spreads might prompt such a decision. Recent political turmoil in France has driven the OAT-Bund spread to its highest level since the European sovereign crisis, raising concerns among policymakers. If volatility threatens to further widen European sovereign spreads, the ECB might reconsider its stance. The ECB aims to continue reducing its balance sheet, having started running off the PEPP facility in July. To maintain this course, it is essential to avoid elevated bond volatility. Although there are currently no signs of contagion to other sovereigns and the OAT-Bund spread has stabilized at a high but acceptable level, renewed political concerns could increase volatility in this sector, potentially prompting a rate cut in September.

At the moment, markets are pricing in an over 80% chance of a September rate cut. However, we believe the risks are skewed towards the ECB not meeting these expectations, which would put pressure on duration.

Implications for Financial Markets

A data-dependent ECB is likely to keep the German yield curve inverted for an extended period. Given the underlying economic strength, a bond bull rally across maturities is unlikely, even if the ECB implements a few rate cuts by year-end.

The front end of the curve offers a favorable outlook under both rapid and gradual rate cut scenarios. Conversely, the long end of the yield curve will remain volatile and susceptible to economic rebounds, a higher long-term neutral rate, and increased term premiums. As such, we advise caution with ultra-long duration investments as in this segment of the yield curve, data will play a more critical role than central bank actions.