ECB Review: Hawkish Cut, but Do Not Rule Out Another Cut This Year Just Yet

Summary

• The ECB cut 25bp as expected.
• The presser was more hawkish, especially around comments that they are ‘in a good place’ after the cut.
• This and the updated dovish forecasts suggests room for the economy to outperform, further quashing need for another cut.
• However, we are wary that their assumptions on tariffs look optimistic. 9 July is a tight deadline to make a deal, and we think a 20% (post-deal) tariff is realistic.
• As such, despite the fundamentals not justifying more cuts, the ECB could cut again this year.

Market Implications

• We like EUR STIR steepeners given risk of another cut and our belief that the labour market is too tight to justify easy monetary policy.
• We consider the EZ inflation outlook stronger than the market is pricing.
• In our model portfolio we retain ERZ5/Z6 steepeners, targeting 55bp and higher 1Y EUR inflation swap, targeting 1.9%.

Hawkish Cut, Retain EUR STIR Steepeners

The ECB cut rates by 25bp as expected. But President Lagarde’s comments that ‘we are in a good place’ after the latest cut, has seen the market pare pricing further cuts this year (from 1.7% to 1.8%, Chart 1). The fact that forecasts look quite dovish despite this statement suggests a low bar for hawkish surprises, but risk exists for a negative surprise on US tariffs.

The market unsurprisingly pared rate cuts for the year. We had been considering going outright short EUR STIR, but we still prefer steepeners (Chart 2). We do not see the economy as justifying further cuts. However, the ECB’s baseline assumption for US tariffs on EU goods is just 10%, so strong risk exists of bearish surprises that may justify further cuts near-term. If this risk is avoided (favourable US-EU deal), then the market can begin pricing 2.0% as the base for deposit rate.

Tight Deadline for Trade Deal

The EU has just over a month (9 July deadline) to deliver a deal to avoid 50% threatened tariffs. The EU functions slowly, is hobbled by its limited mandate that member states provide with restrictions. As such, it is not unlikely that the 50% tariffs are imposed and a 20% final deal tariff is agreed.

Our conclusion on the ECB remains:

• Eurozone economy is strong, and the labour market is tight and tightening.
• This and fiscal spending provide upside risk to medium-term inflation.
• Tariff risks to output, and exposure to Chinese dumping risks are exaggerated.
• ECB reaction function provides scope for it to cut again this year, but this will need reversing it if it does.
• 1Y EUR inflation swap will rise again to around 1.9% (from 1.5% current).
• Euribor STIR will steepen as the market prices future hikes.

Updated ECB Forecasts Leave Room for Hawkish Surprise

Inflation Revised Down on FX and Energy

As expected, near-term headline inflation was revised down on a stronger EUR and weaker energy prices (Chart 3). Meanwhile, core was revised up in near term, but reaches the same horizon end around 1.9%. Services were revised up near term but are forecast to drop lower in 2026, before settling around 2.5% (Chart 4).

Overall, this medium-term forecast at target (as it generally is), supports their ‘we are comfortable with rates where they are’ comment. But the sharp decline in headline assumed on continued EUR strength and energy weakness sets a relatively low bar for hawkish surprises.

Bearish Labour Market Bias Retained

The ECB has continued its trend of forecasting labour market deterioration. They forecast the unemployment rate rising to 6.4% by year-end and employment flatlining in mid-2025, followed by slow growth in 2026 (Charts 5 and 6).

We are more bullish the labour market (and have been since the start of 2025). While employment may see headwinds from manufacturing weakness, we see the tariff impact as limited (even at 20%) and expect unemployment can still drop as demographics and refugee returns reduce the working-age population.

They have made minimal changes to the forecast for wage growth beyond a downward revision near term (Chart 7). Meanwhile, productivity growth has been revised mostly downward. While cost-push inflation may be a concern if productivity underperforms, we think the bigger risk is demand-push from a very strong consumer purchasing power (employment x wages).

Q1 Growth Beat Expected to Reverse

After Q1’s strong beat (on frontloading net-exports and Ireland’s outperformance), QoQ GDP growth is expected to see a strong reversal in Q3 on unwinding of frontloading and a tariffs rise. This is expected to be followed by a modestly stronger performance in 2026, supported by higher disposable incomes (Chart 8).

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