Traders Expect an ECB Rate Cut

Traders are ramping up bets on monetary easing from the European Central Bank (ECB) next year, raising the stakes for President Christine Lagarde as she prepares for a policy meeting next week.

Earlier today, markets fully priced six quarter-point rate cuts by the ECB in 2024, a move that would take the key rate to 2.5 percent. Although bets were pared slightly later in the day, Deutsche Bank helped stoke the dovish sentiment by revising its outlook to also forecast 150 basis points (bps) of cuts.

While policymakers are still warning of the threat posed by inflation, a slew of dovish comments in recent days have suggested hikes above 4 percent will likely not be needed due to the decline in inflation. Markets are now pricing in an almost 90 percent chance of the easing cycle starting in the first quarter of next year, a scenario that was barely contemplated just three weeks ago.

If the traders are right, the ECB will be the first among major central banks to cut rates next year, and will deliver the most aggressive easing cycle. In the United States, where headline inflation has slowed to an annual pace of 3.2 percent, the Federal Reserve is expected to deliver its first move in May and lower rates by 125 bps in total.

“Given the latest inflation data and the tone of official commentary, we fear we were too timid,” economists at Deutsche Bank led by Mark Wall said Wednesday in a report to clients. “The risk is now earlier and larger cuts, and an ECB more capable of decoupling from the Fed.”

Deutsche now sees the first rate cut coming in April rather than June, with a “significant risk of a cut” in March and 150 bps of easing in total through the end of the year.

Bond Rally

The view that the ECB and other major central banks will have to ease monetary conditions to support their economies next year has boosted bonds. The yield on 10-year German bonds has dropped about 80 bps, to 2.23 percent, over the past two months—the lowest level since May.

That’s led some in the market to start cautioning against excessive optimism. Strategists at BlackRock Inc. say they “see the risk of these hopes being disappointed,” and Goldman Sachs Group Inc.’s strategists are recommending options bets to counter excessive rates pricing.

Stephanie Niven, portfolio manager at Ninety One, says Eurozone rate cuts are more likely to emerge at the end of next year, given that central bankers have been guiding toward a higher-for-longer scenario. Lagarde has warned that the medium-term outlook for inflation remains highly uncertain.

“It’s interesting looking at all the narrative around Europe, the flip-flopping that we’ve seen just in the last three weeks,” Niven said in a Bloomberg TV interview. “Europe has both cyclical and structural challenges, and that’s what causing a lot of that oscillation and volatility about what markets are really expecting the ECB to do.”

Eurozone consumer prices grew less than expected in November, by 2.4 percent year-on-year, down from 5.3 percent in August. That’s closer to the ECB’s 2 percent target than at any point since mid-2021.

At the same, economic data shows further signs of weakness. German factory orders unexpectedly fell in October, highlighting how manufacturing in Europe’s largest economy remains stuck in a rut.

“The European economy has been steadily deteriorating over the past 12 months as financial conditions have tightened,” said Gareth Isaac, head of multi-sector portfolio management at Invesco. He expects labor markets to soften next year, “providing the ECB with the cover to begin cutting rates sharply as inflation falls back to target.”

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