ECB Monitor: When to Fade ECB Cuts

Summary

• The ECB will likely cut rates by 25bp this week given trade tensions and the recent CPI miss.
• While the doves will hold the reins near term, pushbacks should begin to grow.
• Updated medium-term forecasts must contend with low productivity growth, labour market tightness and rising fiscal spending.
• We do not think the ECB fundamentally needs to cut further, but they will nevertheless probably cut to 1.75% this year.

Market Implications

• The market is under-pricing 1Y inflation risk.
• If the ECB cut to 1.75% this year, we expect they would need to hike back soon after (we like STIR steepeners).
• If the market prices in additional cuts, we would consider going outright short EUR STIR.

How Low Will the ECB Cut?

The ECB will most likely cut the deposit rate by 25bp this week. They will also update their macroeconomic forecasts.

Revisions to inflation expectations will probably be downwards near-term on energy, but medium-term forecasts must account for labour market tightness. That may make it difficult for President Lagarde to sound too dovish. For now she will probably play up uncertainty given the tariffs.

The market is pricing further cuts down to around 1.55% over the next 12 months (Chart 1). This would be materially in expansionary territory according to most ECB policymakers and models, which we do not think the data justifies.

Nevertheless, for now suppressed energy prices and tariff uncertainty alongside recent EZ inflation misses will keep the ECB dovish. However, we think the market is overpricing inflation and the employment downside from the trade wars.

Further out, we think the economic rationale for cutting into expansionary territory is weak, and there is value positioning for Euribor STIR steepening and higher 1Y EUR inflation (currently around 1.46%).

Ahead, there may be increased value in going short the EUR short end if the market priced additional cuts below 1.5% without a significant deterioration in economic conditions.

Inflation Less Dovish Than First Appeared

Preliminary headline HICP dropped to 1.9% in May, with core dropping to 2.3%. Both were below market consensus, and headline is sizeably below ECB forecasts from May (albeit with volatility, Chart 2).

While YoY services inflation dropped sharply to 3.2%, YTD services inflation remains decently above typical (Chart 3). It roughly aligns with 2022’s rate. How the typical summer price rises and H2 discounting pan out will be important to watch.

That core inflation is above expectation, and services remain strong suggests current dovishness may not last too long. This is especially the case in wage-intensive services (data out to April), which are even higher above typical than broader services (Chart 4). Our hawkishness on this would be stronger if May’s final data confirmed non-wage-intensive services (such as transport) were driving the paring in rate.

The ECB is likely to revise down its near-term inflation on the energy price decline and recent CPI miss, but they cannot ignore the more core elements for too long. Labour market dynamics (below) should support these elements medium term, and we note that consumer expectation surveys have flagged the divergence higher (Chart 5).

Labour Market Remains Tight

We think the labour market is tight and tightening. Tariffs, and manufacturing pain are unlikely to derail this. The ECB must revise employment up and unemployment down in their new forecasts, which should support medium-term core inflation (Charts 6 and 7).

Negotiated wage growth having slowed sharply will comfort the doves (Chart 8). Meanwhile, vacancies slowing is big news (Chart 9). Our take is:

1. While wage-intensive services inflation remains elevated, it is less cost-push than demand-pull (wage x employment) inflation that should be concerning.
2. ECB negotiated wage growth number were volatile through 2024 and most wage-growth metrics remain elevated versus pre-COVID.
3. While vacancy numbers are normalising, by Eurostat metrics they remain elevated versus history. Indeed’s numbers suggest this is particularly the case versus the US and UK (Chart 9).

GDP – Consumer Rebound Will Be Key

GDP has overshot in Q1 but only when including Ireland’s outsized impact. Excluding this, the EZ economy grew slower than forecast (Chart 10). We do not have the data to say what drove this yet.

Regardless, consumers’ strength and confidence is key going forward. Upside potential exists if the savings rate begins decreasing, but downside risk exists if they continue rising. For now consumer confidence remains subdued versus pre-COVID.

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