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Summary
- The market is fully pricing a 25bp cut in September. However, recent data suggests the ECB will need to revise their forecasts more hawkishly at the September meeting.
- This, and the amount of incoming data, elevates the risk of the ECB pausing in September. We therefore see good value in fading the 25bp cut priced.
- The ECB must account for strong labour market and sluggish growth – together, they point to lower productivity growth than assumed and, consequently, higher medium-term inflation pressures.
Market Implications
- New Trade: Fade the September 2024 cut on the risk of further hawkish data. We enter at 25bp.
- We are considering the strategic value of paying 10Y EUR swap versus receiving 10Y GBP swap. There could also be value in paying it outright.
Market Fully Pricing September Cut – It Is Anything But Certain
The ECB will meet on 12 September to decide policy and update forecasts. The market is fully pricing a cut at that time.
However, this week will be heavy on surveys and data. We have previously warned of high risk the ECB cuts less than currently priced. This could extend to not cutting in September. A big question that the ECB will need to answer is whether the medium-term inflation conditions have improved since June to justify a cut.
Based on the most recent data, our lean is that the ECB will need to revise employment assumptions higher and GDP forecasts down. Together, this suggests more elevated medium-term inflation pressures from lower productivity. Along with the recent beats in inflation, this may be enough to justify another pause.
We do not currently have a very strong conviction about the September decision (particularly given the amount of survey data out this week). However, we see good tactical risk-reward in fading the current 25bp priced.
We also note that the spread of GBP 10Y swap rate over EUR 10Y swap is very elevated, particularly in real terms (we have written on the suppression of the EUR 10Y real rate before). We will investigate in more detail ahead.
Inflation Falling Too Slowly for ECB
July headline YoY inflation rose to +2.6%, while core was stable at +2.9% – both sit above the ECB’s forecast from June (Chart 1). The momentum in both is also rising above levels consistent with the 2% target (Chart 2). Note: services inflation momentum is falling, but this is in line with our expectations and the recent strong summer seasonals.
Labour Market Still Tighter Than ECB Had Expected
The ECB is in a bind over the labour market. Continued labour hoarding even amid anemic economic growth presents productivity issues. While the unemployment rate has risen back in line with ECB forecasts (Chart 3), employment growth has outperformed (Chart 4).
More near term, the ECB wants wage growth to keep slowing (Chart 5). For now, that appears to be happening. But if this week’s Q2 negotiated wage growth remains hot, it would be hard for them to overlook (recall, they looked through Q1’s beat on the back of one-off rises).
Slow GDP Growth Is Not Dovish
While usually a slowing economy would suggest a need for looser policy, it does not for the ECB while the labour market remains so tight. Lagarde repeatedly mentioned at the last presser that the bloc needed stronger demand to justify the employment level.
Currently, the ECB’s forecasts appear slightly optimistic in 2024 and 2026 versus market expectations (Chart 6). This could mean they need downward revision at this round of forecasts. The one saving grace is that some of this underperformance in growth can be attributed to Ireland’s outsized impact. Excluding this, Eurozone growth has been stronger than ECB expectations (Chart 7).
(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.)