For the first time in over a year, traders are struggling to gauge whether the European Central Bank will raise interest rates at its next meeting, with the outlook blurred by still sticky inflation and a stuttering economy.
Data on Thursday showed euro zone inflation held at 5.3% in August rather than dropping. A core measure excluding volatile food and energy prices dropped more than expected, to 5.3%, but remained far above the ECB’s 2% target.
Coming just a week after business activity numbers pointed to a darkening economic outlook, the data have added to a lack of clarity for investors who for the past year have confidently priced successive rises in euro zone interest rates.
On Thursday, money markets were pricing in around a 30% chance of a 25 basis point hike at the ECB’s Sept. 14 meeting, down from as high as 60% last week.
Danske Bank chief analyst Piet Christiansen said traders’ indecisiveness reflected “the battle between the growth and inflation outlooks”.
Demonstrating the difficulty of calling the ECB’s move, trader bets over the past week have repeatedly swung between expecting a pause and a hike.
Such uncertainty increases the scope for increased volatility for bond markets and the euro heading into the September meeting.
Latest inflation prints suggest price pressures are still troubling the bloc, but with business activity contracting sharply, signalling deeper economic pain ahead, further rate increases are no longer a done deal.
Indeed, it was last week’s forward-looking PMI activity data that pushed investors to price in a pause.
“This balancing act is playing out right now,” Christiansen said, adding he still expects a 25 bps hike in September, given the ECB’s mandate to keep inflation in check.
Even ECB board member Isabel Schnabel, a hawk, on Thursday refrained from taking a firm view, but said a weakening economy does not automatically void the need for more hikes.
Another inflation hawk, Austrian central bank chief Robert Holzmann, said the ECB could deliver “another hike or two”.
PAUSE COMING
For those eyeing a pause, the lagged impact of 4.25 percentage points of ECB tightening over the last year are becoming more pertinent.
Lending growth to companies slowed further in July, adding to mounting evidence that the ECB’s sharply higher interest rates are curbing credit creation and growth.
Overall money supply in the bloc contracted in July for the first time since 2010, demonstrating the extent to which ECB policy has tightened financial conditions.
“We went from a scenario where the ECB was the one likely to keep hiking because of inflation ... to a more complex scenario, where it is harder for European central bankers to assess the impact of monetary policy and in particular the time for that impact to materialise,” said Mauro Valle, head of fixed income at Generali Investments, which manages 505 billion euros in assets.
Valle said it was now harder for the ECB “to balance the monetary policy in order to both avoid a recession and bring inflation down”.
Euro zone government bonds have whipsawed in recent days amid U.S. and European data releases but were less hit by a selloff raising U.S. Treasury yields overall in August as investors expect a weaker economy than across the Atlantic.
“It’s a difficult task for investors to get a grip on where bond yields should go over the medium term,” said Edward Hutchings, head of rates at Aviva Investors, who favours a small overweight in bonds across the European region.
The euro, trading at around $1.09, has shed 1% in it biggest monthly fall since May. A pause or end to the hiking cycle could hurt over $20 bln euros of investor bets on the euro rising further, according to CFTC data.
And even if investors are divided on September’s decision, the consensus is that the ECB will be done raising rates soon.
“If they decide that another hike is warranted, it’s a case of now or never,” said Frederik Ducrozet, head of macroeconomic research at Pictet Wealth Management.
More important for markets than the rates decision itself may be what ECB chief Christine Lagarde says.
“As we are getting ever closer to the end of the tightening cycle ... the narrative for us becomes far, far more important,” Aviva’s Hutchings said.
Longer-term, markets expect the ECB to start cutting rates by the second quarter of 2024.
“The difficult part will be for Lagarde to keep a hawkish bias at the peak while preventing markets from pricing in rate cuts prematurely,” Pictet’s Ducrozet said.
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