ECB Firmly on Hold

While interest rates have presumably peaked, we remain skeptical that rate cuts will be delivered as forcefully as the market expects.

The European Central Bank (ECB) left its policy rate unchanged at 4% in January, and did not discuss rate cuts. The market is envisioning quick and immaculate disinflation, and an early and sharp monetary policy reversal, as reflected in the five and a half 25-basis-point rate cuts priced for this year, starting around April, and a terminal rate of about 2% priced in 2025. As a result, financial conditions are currently considerably looser than those embedded in the ECB’s December macroeconomic projections.

We remain skeptical that the ECB will deliver rate cuts so early, with core inflation still elevated and the outlook for medium-term inflation unclear, and we believe cuts will more likely begin from June or later this year. Indeed, we expect the ECB – mindful that its primary mandate is price stability – will wait for more clarity on wage data rather than risk the need to reverse course and resume hiking.

As for investment implications, current valuations leave us more cautious on European duration near term. Amidst elevated issuance needs, ending reinvestments weakens the relative technical picture for government bonds, and speaks to a continued rebuild of term premia over time. We expect the back end of interest rate curves to underperform relative to shorter maturities.

Interest rates: waiting for wage data

As it did in December, the ECB acknowledged the progress made on inflation, but the Governing Council refrained from declaring victory and instead highlighted the need to remain data-dependent, attentive to the different forces affecting inflation, and focused on bringing inflation back to target.

Eurozone headline inflation stood at 2.9% year-over-year in December, with core inflation at 3.4%. These numbers are well below the peaks of 10.6% in October 2022, and 5.7% in March 2023, respectively. Notwithstanding, for inflation to evolve in line with ECB staff projections and converge to its 2% target, it will require firms to use profit margins to help limit the impact of current strong wage increases to consumer prices, as well as wage growth to fall back to levels that are broadly consistent with 2% inflation, and productivity to rebound.