After the European Central Bank cut its deposit facility rate by 25 basis points on Thursday 17 October, markets are now pricing in further rate cuts at the next board meeting in December. Economists are currently considering the fate of inflation, slowing growth in countries such as Germany, and the impact on bond markets.
President Christine Lagarde offered no guidance on future interest rate trends at her monthly press conference, instead focusing on falling inflation and weak economic data. Forecasts after the meeting were divided among market commentators. For some, the path forward is clear. Interest rates need to be lowered quickly in successive meetings. For other countries, the ECB's guidance remains completely unchanged and its “data-driven, meeting-by-meeting approach” continues, meaning a flurry of interest rate cuts is not a done deal.
“It is becoming increasingly clear that the ECB's gradual monetary easing is not enough and that continuous rate cuts are needed,” said Seema Shah, chief global strategist at Principal Asset Management. Ta.
Shah believes that while inflationary pressures may continue to stress central banks, “the alarming situation in the euro area economy suggests that the path forward is fairly clear.”
Ulrike Kastens, European economist at DWS, said further significant interest rate cuts were expected in the coming months, “especially as the debate about economic weakness gains momentum between now and the next ECB Governing Council meeting in December.” I predict that.
Henry Cooke, senior European economist at MUFG, said the ECB was sticking to the same scenario and continued its data-driven approach. Looking ahead, he believes the December meeting “looks like a turning point that could move from the current flexible stance to a firmer commitment to future mitigation.”
Eurozone disinflation? Prepare for stagflation
Markets are pricing in a final or “neutral” rate of 2% sooner than expected due to current disinflation and increased risks to economic growth. Experts say that while a recession is not the base case for now, investors need to prepare for a variety of scenarios.
“The idea that a slowing economy = lower inflation has proven inadequate in the past, leading central banks to misjudge inflation as temporary.The ECB insists it relies on data. “However, they seem to focus on data that fits traditional models, ignoring the risk of stagflation, a mix of stagnation and inflation,” said the Frosbach von Storch Institute. said Pablo Duarte, senior research analyst. Morning star.
He argues that the money supply continues to increase without corresponding to real economic growth.
“More money being pumped in pursuit of fewer assets generally leads to higher prices, while lower interest rates encourage credit expansion,” he said, adding, “The ECB is pursuing deflation. “However, it is clear that significant inflation risks remain.”
Are inflation expectations too low?
ECB President Lagarde emphasized that “the process of eliminating inflation is progressing smoothly.'' Still, economists disagree on the future rate of inflation after the euro zone inflation rate fell to 1.7% in September from 2.2% in August 2024.
Wellington Management macroeconomist John Butler believes inflation expectations are too low: “The market's long-term inflation expectations remain around 2% for most countries. I think this is too low. Over time, markets will need to revise their expectations upward.''As a result, not only will inflation be higher in the medium term, but cyclical fluctuations will also be more pronounced. ”
Peter Vanden Hout, chief economist at ING, said higher energy prices due to conflicts in the Middle East could push up headline inflation, but he does not expect this to have a lasting impact.
“We have actually lowered our headline inflation forecast for 2025 to 2%,” he said on October 10. Vanden Hout is far more concerned about economic growth. A gradual recovery is expected from the second quarter of next year onwards. ”
ING revised its 2025 GDP growth rate downward to 0.6%, the same as the 2024 growth forecast, and below the ECB's official forecast.
What is the impact of Germany's recession?
The actual level of interest rates is still considered restrictive by economists, leaving room for future decisions depending on data flows.
“While an upside shock to inflation, if it materializes, could be responded to by slowing the pace of future rate cuts, lower rates provide further protection against downside risks,” said Konstantin Veit, portfolio manager at PIMCO. ” he said.
While financial markets viewed October's rate cut as a transition from gradual to gradual rate cuts, Tomasz Wiladek, chief European economist at T. Rowe Price, insisted it was an “insurance” rate cut. The weak German economy is a cause for concern, he said.
“However, this is likely the result of structural headwinds related to a significant decline in competitiveness following the 2022 energy shock, intense competition from China, and an aging population.
“Monetary policy cannot influence these factors, and policymakers are aware of this. If Germany deletes its data, the rest of the eurozone will not only be affected on the growth side, but also on the labor market. It will remain very resilient.”
What to expect from the bond market?
Patrick Barbe, head of European investment grade fixed income at Neuberger Berman, believes the bond market does not reflect the challenges facing the German economy.
“The ECB's key interest rate is pushing up yield levels on short- and medium-term bonds, pushing German yields above where they should be based on fundamentals,” he said on October 16.
“We wonder when [ECB] When it began cutting key interest rates in July last year, it was already taking Germany's problems into account. And we believe that the 'non-recovery' of industries in major eurozone countries justifies another rate cut towards a neutral monetary policy stance. ”
“This rate cut is likely to further the steepening trend we're seeing in the government bond market,” said Michael Krautzberger, global CIO of fixed income at Allianz GI.
Markets are also taking into account the divergence between the eurozone and US economies. This could cause the euro to weaken against the dollar and push up yields on 10-year U.S. government bonds, Italian investment bank Intermonte said in a note after the ECB's board meeting. this
For investment grade bonds, Celia Soares, client portfolio manager at Janus Henderson, said that in terms of total euro investment grade yield, this quarter, excluding the impact of Q4 2023 and COVID-19, pointed out that it was the best in 12 years. “Some sectors, such as real estate and utilities, may benefit more than others from lower interest rates,” he said in an Oct. 17 note.
