Traders Ramp Up Bets on ECB Rate Cuts at 2.5%

Traders are increasing their wagers on monetary easing by the European Central Bank (ECB) in the coming year, elevating the stakes for President Christine Lagarde ahead of an impending policy meeting next week.

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On Wednesday, markets fully priced in the expectation of six quarter-point rate cuts by the ECB in 2024, potentially taking the key rate to 2.5%. Although these bets were slightly scaled back later in the day, Deutsche Bank contributed to the dovish sentiment by revising its outlook, now forecasting a total of 150 basis points of cuts.

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While policymakers continue to sound warnings about the threat posed by inflation, a series of dovish comments in recent days indicate that significant hikes, particularly above 4%, may not be necessary due to the decline in inflation. Markets are now indicating an almost 90% likelihood of the easing cycle commencing in the first quarter of next year—a scenario that was scarcely contemplated just three weeks ago.

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If traders' expectations materialize, the ECB would be the first major central bank to cut rates next year and would undertake the most aggressive easing cycle. In the United States, where headline inflation has slowed to an annual pace of 3.2%, the Federal Reserve is anticipated to make its first move in May, with a total reduction of 125 basis points.

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Deutsche Bank's economists, led by Mark Wall, expressed a shift in sentiment in a report, stating, “Given the latest inflation data and the tone of official commentary, we fear we were too timid. The risk is now earlier and larger cuts, and an ECB more capable of decoupling from the Fed.” The bank now foresees the initial rate cut occurring in April, rather than June, with a "significant risk of a cut" in March and a total easing of 150 basis points by the end of the year.

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This anticipation of monetary easing across major central banks has led to a bond rally. The yield on 10-year German bonds has declined by around 80 basis points to 2.23% over the past two months, marking the lowest level since May.

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However, some market participants are urging caution against excessive optimism. Strategists at BlackRock and Goldman Sachs are highlighting the possibility of hopes being disappointed, with the latter recommending options bets to counteract potentially exaggerated rates pricing.

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Stephanie Niven, portfolio manager at Ninety One, suggests that rate cuts in the euro area are more likely to materialize towards the end of next year, given central bankers' indications of a higher-for-longer scenario. Lagarde has emphasized the high uncertainty in the medium-term outlook for inflation.

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Reflecting on the market's expectations, Niven pointed out the oscillation and volatility witnessed in the past three weeks, attributing it to both cyclical and structural challenges in Europe. Euro-area consumer prices in November grew less than anticipated, at 2.4% year-on-year, closer to the ECB's 2% target than at any point since mid-2021.

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Simultaneously, economic data indicates ongoing weakness, with German factory orders unexpectedly falling in October, underscoring the persistent challenges in Europe's largest economy.

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Gareth Isaac, head of multi-sector portfolio management at Invesco, anticipates labor markets softening next year, providing the ECB with the rationale to initiate significant rate cuts as inflation retraces to the target level.