New Trade: ECB Monitor – Short ERZ5

Summary

• ECB voters have started discussing where R* is. But there is little appetite right now in discussing cutting below the neutral rate.
• We estimate consensus R* is around 2-2.5%, making the market pricing (1.70% in October 2025) look overly dovish.
• The US election outcome has driven some of this. It probably underestimates the reality that trade wars are inflationary.
• Greater EZ fiscal spending could further reduce the need for the ECB to ease on export declines.
• The PMIs were very negative, but they are not a good indicator of hard data. The ECB are aware of this. We would ignore them as a determinant of policy.
• Rising gas prices could be a concern, particularly if core and services momentum continue to match those of a year ago. ECB should be wary cutting too fast ahead of Q1 repricing data.

Market Implications

• We see very low chance that the ECB cuts by 50bp in December, nor do we consider the current data and ECB comments sufficient to justify pricing cuts below neutral.
• New Trade: We turn short ERZ5 futures at 98.18, targeting 97.87, with a stop at 98.30.

Little Consensus for ECB to Cut Below Neutral Yet

Recent comments by policymakers (see appendices) have begun to broach the subject of where neutral is, and how fast they need to cut there. Some of the hawks have been explicit that they do not need to cut below neutral (Schnabel), while the most dovish voices (Stournaras, Panetta, Centeno) are focused on getting to neutral quickly, content to discuss later whether to cut below it.

Estimates of neutral among policymakers range from 2% (Stournaras), up to perhaps as high as 3.5% (Vasle). 2-2.5% seems to be about consensus right now (Chart 1).

On this basis, the market pricing for cuts down to 1.70% sits on the most dovish end of the spectrum (Chart 2). Meanwhile, despite Centeno’s comments, we see the likelihood of a 50bp cut in December as low (not the 50% the market is pricing).

This adds to our view that ECB cuts can be faded. We turn short ERZ5 futures at 98.18, targeting 97.87, with a stop at 98.30.

US Election Not so Dovish for ECB

Part of the market dovishness may be justified by bearishness on the US election outcome, and particularly the threat to growth from tariffs. We have previously set out the case for this, but also why the situation may be avoided by agreement to buy more US weaponry.

However, there are several reasons why the result should not be dovish for the ECB:

• ECB dovishness will not resolve the external demand issues from rising tariffs.
• Trade wars and deglobalisation are inflationary forces (ECB members Nagel, Rehn, Kazaks agree).
• Trump 2.0 will likely drive higher government spending (in support of Ukraine, to shore up defence and to invest in infrastructure). This expansion will add demand that the ECB will not want to exacerbate.

While in the near-term the ECB is relatively optimistic on the progress that disinflation has made, and have warned there could be downside risks to growth, we are wary that the current pattern of inflation could open up a stronger bounce from target than they expect (especially if energy prices rise – more on that below).

Ignore the PMIs

The market added 10bp of cuts after this morning’s PMIs came out weaker than expected. We see little value in the reading – EZ PMIs have not tracked with hard data since COVID and have shown strong seasonality (with overly positive H1s and overly negative H2s). This pattern continues to play out (Chart 3). The ECB is aware of this.

Upside Inflation Risk from Gas Prices

Russia is keen to prove its red-lines matter. They have reportedly fired an ICBM at a Ukraine civilian target and announced they will cut Austria off from piped gas. On the latter, the price of European gas rose, and now sits close to their highest price in a year. A cold spell could add to the upside risk. If prices stay elevated, the YoY impact on prices will begin to re-accelerate (Chart 4).

As we have noted previously, a re-acceleration in services and core into the start of the year remains a risk given that the price pattern has matched that of 2023. If energy prices do remain high, while core and services inflation follow the Q1 2024 pattern, then there is a risk that through Q1 headline CPI continues to overshoot target.

Europe Unlikely to Run out of Gas

Despite the reduction in supply to Austria, this is more of a risk to prices than output. Europe is currently well supplied with gas; its inventories are high and capacity to receive LNG continues to grow (Charts 5 & 6).

It should be noted that c.20% of LNG comes from Russia (mostly to France & Spain) supply of which could be at risk, but Europe can readily source from elsewhere (likely the US). It would just need to pay more for it.

Based on all the above, the market now pricing cuts below neutral rate, with a 50% risk of a 50bp cut in December seems very attractive to fade. We see value being short ERZ5 futures at 98.18, targeting 97.87, and stopping: 98.30 (Chart 7).

Appendix 1: Policy Maker Comments

Appendix 2: ECB Minutes Comments

Inflation

• Inflation is moderating (September numbers). Cannot use short-term movements in headline as a guide for the medium-term outlook. Progress in core has been more limited.
• Still too early to declare victory on sustainable return to target
• Headline CPI expected to rise into YE but return to target in 2025, earlier than previously expected. Disinflation well on track
• Downside to inflation higher, upside smaller

Growth

• Economic activity indicators surprised to the downside, weighing on inflation outlook.
• Plausible that higher real disposable income would eventually translate into higher consumption.
• Negative news mainly from soft survey data, while new hard data limited and giving contradictory signals.
• None of the demand components – consumption, investment or exports – had yet shown the strengthening that was foreseen in the September staff projections.
• Risks to economic growth remained tilted to the downside

Wages

• Incoming wage growth signals for 2025 in line or below September projections.
• ECB forward-looking wage tracker corroborated expectations that wage pressures would ease in 2025

Policy Transmission

• Argued that the closer rates are to neutral territory, the more cautious one would have to be that monetary policy did not itself slow disinflation.
• Lower interest rates and better housing market prospects led to a strong rise in demand for mortgages (actual mortgage lending up +0.6% annual rate)
• Growth in lending to firms and demand for bank loans by firms remained weak.
• The change in market expectations and sentiment had been rapid and substantial since the September meeting
• Pass-through of past policy rate increases gradually fading, an initial indication that bank lending rates would ease from restrictive levels
• There should be no pre-commitment to a particular rate path –
• Policy stance might be approaching the estimated neutral territory earlier than previously thought. Almost the entire euro area real rate curve was currently close to neutral territory.

Fiscal

• With limited fiscal space available looking ahead, it was widely felt that even more emphasis needed to be put on structural policies that fostered economic activity by enhancing the growth potential

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)