Traders Optimistic on Inflation Outlook
Traders are increasingly confident that the European Central Bank (ECB) will lower interest rates starting in April, reflecting a positive shift in policymakers’ perception of the inflation outlook. ECB President Christine Lagarde reiterated in a news conference that it was premature to discuss rate cuts after keeping the key rate at a record 4%. Notably, the central bank removed a mention of elevated domestic price pressures due to strong growth in unit labour costs. This move is seen as a sign that the ECB believes wage growth, the main risk to inflation, is slowing.
Market Reaction and Rate Cut Bets
As a result, traders have significantly increased their bets on an interest rate cut. Two-year bond yields, which are sensitive to interest rates, experienced a sharp decline. Prior to the meeting, the probability of a 25 basis-point rate cut in April stood around 60%. However, it has now increased to over 80%. Furthermore, the expected total rate cuts for the year have risen from around 130 basis points to 140 basis points. Market participants have interpreted these developments as an indication that the April meeting is significant.
Danske Bank chief analyst Piet Christiansen stated that the main message for the markets is that the April meeting is live, and if wage growth and inflation figures align with expectations, a policy rate cut can be expected. The rally in bonds reflects the absence of any pushback from the ECB against market rate bets. German and Italian two-year bond yields experienced their biggest drop in nearly two weeks, while the euro fell approximately 0.5% against the dollar.
Cautious Investor Outlook
Although rate cut expectations have bolstered bond markets, some investors have cautioned that there may be limited room for further yield declines. Florian Ielpo, head of macro and multi-asset portfolio manager at Lombard Odier Investment Management, mentioned that his firm maintains an underweight position in bonds and an overweight position in equities. Ielpo believes that equities have not fully priced in the potential earnings support from lower interest rates.
Lagarde emphasized that the ECB’s decisions will be data-dependent and reiterated her previous comments indicating a potential rate cut in the summer. The availability of sufficient wage data in late spring is vital, and chief economist Philip Lane is keen to review the April data before considering any easing measures. ABN AMRO and Danske Bank continue to predict a rate cut in June based on their analysis, while other market participants, such as Dario Perkins of TS Lombard, expect deflation to occur more rapidly in the Eurozone compared to the US.
Note: This Jan. 25 story has been refiled to add the missing word ‘Central,’ in paragraph 1